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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Learning To Invest
Buying a stock is like owning a company. Puzzled? Learn the basics of learning to invest in stock market. Chapter 1: Basic Concepts Chapter 3: Equity Risks Chapter 6: All about financial ratios Chapter 4: Annual Report Explained Chapter 7: Valuing Equities
Learning To Invest In Equity
Chapter 5: Capital Structure
Chapter 2
Equity, shares, stocks so many names. But what do they all mean? Article 1: Are you ready for equities? | Jan 7 2002 Shares are long-term investments that cannot be matched with short-term borrowings. Article 2: Equity means ownership | Jan 10 2002 It means returns are yours. But so are the risks. So you got to understand the business. Article 3: Dividend: the unsung hero | Oct 29 2002 Ignore that paltry dividend cheque at your own peril. Article 4: Equity, thy name is enigma | Jan 3 2002 Why equities? Because the oftmisunderstood equities offer the highest returns in the long run. Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
Chapter 2: Understanding Equities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Understanding Equities Learning To Invest - In Equity Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 7: Valuing Equities Chapter 2: Understanding Equities Chapter 5: Capital Structure Chapter 3: Equity Risks Chapter 6: All about financial ratios
Are you ready for equities?

Last time around, we discovered how investing in equities helps preserve and enhance wealth considerably, compared to FDs/bonds or any other investments. We explored the vital question of ?Why? invest in equities, and now we will endeavour to answer the ?When? and ?How much? questions. We will also delve into ?debt? to understand how it could upset the best of equity investment plans. A farmer in remote Bihar borrows heavily from his zamindar to pay the dowry for marrying off his 11-yearold daughter (an extreme form of debt that we know will turn the farmer into a bonded labourer forever). A newly married yuppie buys a car, TV, fridge on his credit card?(another form of debt that the yuppie hopes to repay with his zooming salaries). In these instances we see that ?debt? has been incurred to spend beyond one?s current means. We learnt last time that typically whatever we earn either goes into buying food, clothes, or assets like a TV, car, etc. Or we save with the intention to use our savings during our retirement or buy a house, etc. In other words, we spend our earnings today or save it to spend it later. ?Debt? brings in a third element?while we postpone consumption when we save, we spend future savings when we borrow! In simpler terms, ? savings? and ?debt? are like day & night?they can never exist together unless it is twilight. Take the case of Nagesh, who we met up with last time. Nagesh is a very practical person who has learnt from the tough times in his life. Nagesh, just like any other human being, has dreams of buying a car, a big house for his family, but realises that he will only be able to get there in stages as his current earning capacity is too limited. He has been keeping his desires in check while continuing to save regularly and investing a part of it in shares of good companies. Nagesh bought a car last month by selling part of his holding in Zee Telefilms (about 100 shares @ Rs3500 that he had bought over a year back @ Rs100). Manish has been Nagesh?s colleague for the last four years. Manish believes in living life king size. In his very first year he exceeded the credit limit on his credit card. He has been paying through his nose, shelling out interest at 3% per month on his credit card outstandings. Two years back, he availed of a car loan to buy a Maruti 800, at a monthly installment of Rs8000 when his post-tax salary was just Rs14,000! Last year, envious of Nagesh?s newfound wealth in shares, he decided to dabble in shares too. His broker recommended Blue Information Technologies Ltd. as a hot tip that would double in 3 months? time! Full of fervour, without even checking the background of the firm, Nagesh pledged his wife?s gold and borrowed to buy this stock at Rs150. A week later, he discovered that the stock had fallen 35% from his purchase price. When he called up his broker, he was aghast to find out that the stock had been suspended. His interest meter was ticking on the money he had borrowed while his principal was down the tube. Talk of the power of compounding! Moral: Never stretch borrowings to invest in the stock market. Shares are long-term investments that cannot be matched with short-term borrowings. Ideally, one should repay all borrowings and then invest the surplus in equities. So, when we are debt free, we are ready to invest in equities! By the way, one is never too old or young to invest as long as one understands the investment one makes. OK, we have understood that in the long run equities offer the highest returns. We have also learnt that one can invest in equities any time provided one has surpluses after repaying debt and meeting one?s expenditure! But how much do we invest? How much depends on two criteria. One, the risk profile of the investor and two, the liquidity requirements of the investor! Now that we know Nagesh, his father and friend Manish well, let us understand this better through their actions. Risk profile! Yes, let?s face it. No equity investments are free of risk. There is no such thing as a free lunch,
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mind you! There are a whole basket of risks to contend with and we will understand all of them very soon. For now, we need to appreciate that there are risks of losing. Looking at our three personalities, we can straight away rule out Manish. He can?t afford to take any risks as he is buried deep in debt and can?t afford to lose a penny! Nagesh on the other hand is just 35 years old and has a long bright career ahead of him, so he can afford to take greater exposure in equities and in slightly risky shares too (for instance, some stocks from our ?Emerging Star?, ?Ugly Duckling? and ?Vulture?s Pick? categories). Nagesh?s father, on the other hand, has retired and has no source of income other than the savings he has amassed. So he will be able to afford very little risk. Hence, he should be looking at stocks in our ?Evergreen? or ?Apple Green? categories to choose his investments (which is why, if you remember, Nagesh had suggested HLL to his father). Let us now move on to liquidity. Liquidity requirements signify the need of cash to meet one?s payment obligations (and don?t have anything to do with human beings? fluid intake). Manish needs all the money he can get as he has to meet so many of his loan obligations. Nagesh on the other hand has an idea of his monthly expenses so he has a better fix on his monthly cash requirements. He also needs to maintain a certain amount of cash in liquid savings (savings bank deposit, etc.) just in case there are some unforeseen medical expenses to meet or an unplanned visit to his father?s place. Beyond these requirements, he can look at investing in equities. Nagesh?s father, on the other hand, has to meet his entire expenses from his savings and would have large requirements for immediate cash. Hence, he can allocate a smaller portion of his savings to invest in equities. Judging the actions of the small world of people we know, we have realised that risk profiles vary with age, current financial position, even one?s own personality. Liquidity requirements too depend on similar factors. These two criteria will be different for different people, but one should not lose sight of one?s risk profile and liquidity requirement while investing in equities. Next time around, we will try to understand what we buy when we buy equities!
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Equity means ownership

You have come a long way. We?ve already been through issues such as the need to invest. You also know when you are ready to invest. Now it is time to understand what we exactly buy when we buy equity. So what we now need to figure out is how to evaluate which company to buy. I?m afraid this is where all those fancy sounding valuation tools come in? PE, RONW, ROCE, EVA, etc. Hey, hang on, it?s not as bad as it sounds. Stick around and we?ll demystify all the above in a jiffy. But before you get into the complexities of the various valuations tools you can use and how you calculate them, we must table a fundamental principle: ?Investing in equities is akin to owning a business.? Let?s now explore the full ramifications of this principle. When you put your money in a bank deposit, you take a risk (albeit small, depending on which bank). In return, you get paid a small interest. The bank takes on a higher degree of risk and lends that money at a higher interest rate to some businessman, or to a credit card holder who wants to buy a diamond ring for his wife. The bank pays your interest out of the money he earns from the businessman. Or the doting husband. Whereas, when you buy shares in a company, you are not lending money to the company. By providing capital for the company, which is represented by an equity share, you are participating in the ownership of the company. Clearly, your risk is much greater in this case. Because, in this case, you are entrusting the company with the job of managing risk for you. Relatively, the risk in lending to a bank is limited. For one, most of our neighbourhood banks are nationalised. So bank deposits are perceived to be backed by the government. There is little soul searching to be done as to which bank to choose. Even in doing so, the highest priority is accorded to a Nationalised Bank purely on the safety parameter. Obviously, when you invest in equities, even this notional sense of security, of a government standing guard over your money, isn?t available to you. What kind of business would you like to enter? Let?s look at this another way now. Let?s assume you want to invest your money into a business. How will you decide what kind of business to enter? For starters, it should display the potential to earn you a return in excess of what the prevailing rate of bank interest is, right? Now you need to ask yourself what would be the essential factors in determining this return. And apart from the return angle, what qualitative factors should you be looking for? In the long term, we all look for security. Business, being an entity, is also entitled to aspire for the same. The ideal business would thus have to have horizons where profits can be sustained. Like we mentioned above, there are external factors that determine the direction and growth of the activity. All this would need to be factored into a business plan that would have to sustain itself and grow over a period of years. Of course, on an ongoing basis, we would definitely have to get a feedback on the success of the business. Operations would have to be evaluated from market feedback, while the financial statements would give a view of the profitability of the concern.
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The same concepts apply to stocks Now, here?s the punch line. Everything we discussed above doesn?t apply only to running a business. The same concepts apply, even if you just own shares in the company. We all know of a document called an annual report. This document is the most basic source for information available on the company?s operations. In the annual reports, the directors dwell, at times in length, explaining the nature of operations and the external environment surrounding the business and how it affected the company during the year. If you take the additional effort of finding out the positioning of the company?s products in the marketplace, it would give a fair idea of the company?s reputation in the field it operates. All this with the objective of figuring out how stable the company?s operation is. The company?s progress can be tracked periodically over close intervals of 3 months. This is through quarterly financial statements, the publication of which has been made mandatory by the regulatory authorities. Next comes the question of management issues. The common question that pops up in this context is: ? How do I externally control the business if I do not have a say in the management??. Ok, let?s assume that you are now running the business you chose. Can you, a single individual, handle all functions of the company? For a while, maybe. But once growth sets in, it would be humanly impossible to manage all the functions of an economic activity, viz. marketing, finance, procurement, etc. That?s when your business will need to morph from outfit to organisation status. Wherein the various functions are distributed across individuals, and finally the same is translated into a unified activity. Similarly, as a shareholder, you end up delegating authority to others to run the organisation you have a stake in. Imagine Mr Narayana Murthy (Infosys), Mr Dadiseth (HLL) and Mr Anji Reddy (Dr Reddy?s) reporting to you. That?s exactly how the cookie crumbles. The company whose equity base you have participated in is answerable. To you, as well as other shareholders of the company. Thus, while you as a joint owner have delegated the operations of the company to the professional managers and the employees, the management in turn is responsible to its shareholders. The management communicates through the balance sheet and the AGM, where shareholders voice their opinion on the performance of the company. Infact, shareholders can actually participate in constructive criticism of the operation of the company. What we brought you today was the first step in how to investigate and understand the qualitative issues in a business. We will be taking up the statistical part of our adventure into evaluating stocks in Valuing Equities.
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Dividend: the unsung hero

During bearish times when the Sensex plumbs new depths and the entire market looks like a discount sale, it is natural to doubt the basic assumption that investing in equities really pays off. We have come across stories with bold headings carried by newspapers and magazines: Equities do not fetch good returns in the long run If you had invested in 100 shares of Tisco in the beginning of 1991 at Rs110 per share, you would have realised only Rs130 per share after ten years?. We are not here to make a case for investing in equities for the long haul. We are here to just spare one moment to look at stories like these to see if it is all too simplistic or if we have missed out something. Imagine we actually bought 100 shares of Tisco in 1991 and held on to it till 2001. Would we have received anything for holding these shares during this period? Of course, yes! We would have received dividends every time the company's board declared one. We just checked the company's dividend payout record during this period and figured out that we would have received Rs25 in all for every share held. True that according to the study, from one particular day in 1991 to another day in 2001, (on a point-to-point basis) Tisco could have appreciated by just Rs20. However, any investor holding on to the stock during the period would have realised another Rs25 in the form of dividends. Hmm! More money from stock dividends than from appreciation in stock prices.
How much would we have received in case of Tisco during this period?
Dividends did make a significant difference
Of course we could debate whether it still made returns better et al. There are arguments and counter arguments. After all, one needs to stay invested in good businesses at right prices. Tisco hit a high of Rs300 plus in 1995, that was 300% in four years. But we are not here to prove a point.
We are here to recognise an unsung hero--Dividend!
Dividend is any payment made out of the profits of a company and approved by its board of directors. Most stable companies have a higher dividend payout whereas many growth companies retain profits to sustain their growth rates. However, in no way are dividends insignificant. Remember "power of compounding" ? It transforms the seemingly insignificant dividend inflows into a very significant inflow. Here is a simple illustration.
For a moment, allow us to indulge in an exercise similar to the Tisco example above, a mere point-to-point comparison of the price of the HLL stock over a period of seven years, from end-1993 to end-2000, to understand our unsung hero better.
An investment of Rs1,000 in HLL at the end of 1993 would have been worth Rs3,570 at the beginning of 2001, ie a 20% per annum compounded rate of return over a period of seven years. Comparison of returns on HLL investment between end-1993 and end-2000
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Period Dec - 1993 Dec - 1994 Dec - 1995 Dec - 1996 Dec - 1997 Dec - 1998 Dec - 1999 Dec - 2000 -
CMP of HLL 58 59 63 81 138 166 225 210 -
Investment 1,000 -
Org#Sh 17 17 17 17 17 17 17 17 -
DPS 2.27 3.48 4.40 10.24 13.92 19.86 29.01 35 -
Dividend Reinvested 0 39 0 0 0 0 0 0 -
Addln Sh 0 1 1 1 1 2 2 3 -
Tot #Sh 17 18 19 20 21 23 25 28 CAGR
With Div 5,948 29.01%
W/O Div? 3570 19.94%
Note: CMP = current market price; Org # Sh = no of HLL shares Rs1,000 could buy in December 1993; DPS= dividend per share; Addln Sh = more shares of HLL bought with the dividend payout every year; Tot # Sh = Org # Sh + Addln Sh--the total outstanding investment in HLL; With Div = money/ returns made by reinvesting dividends; W/O Div = money/returns made without dividend reinvestment.
To add a twist to the tale enter our unsung hero?
Let us assume that we reinvest the entire dividend that we get every year on our HLL holding to buy shares of HLL again. So in our case, the 1993 dividend payout would help us buy one more share of HLL. The 1994 dividend would help us buy another share of HLL and so on. Any guess on how much extra we would make? How does a mere 50% improvement in returns sound? Yes, 50%! Our investment of Rs1,000 at the end of 1993 would be worth Rs5,948 at the beginning of 2001, ie a 29% per annum compounded rate of return over a period of seven years! Almost double the money we would have made on our investment if we'd realised only the appreciation in the stock price. If we borrow our learning from "Power of Compounding" and stretch the horizon, then the heroic act of "dividend" hits us really in the eye. In a very simple manner, Rs1,000 turns into Rs95,000 (95 times) if HLL price continues to compound at 20% per annum for 25 years. On the other hand, Rs1,000 transforms into Rs6,00,000 (600 times) if the rate of return improves to 29% because of dividend reinvestment over a period of 25 years. If our investment horizon is 25 years and we decide to make the seemingly paltry dividends that we earn work for us by reinvesting them, we might actually make six times more than what we would if we didn't reinvest the dividend every year. In the long run, investments in stocks are attractive as much for the dividends they pay out as much as for the appreciation in their prices. It is no coincidence that in both the cases (Tisco and HLL) we saw the returns double when reinvestment of dividend was taken into account. So the next time your company declares a dividend, you know exactly what to do?
Did we read somewhere that tiny drops of water make a vast ocean?
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page If one were to conduct a survey to determine how people saved for their retirement, one would typically get the following responses... ?I put my money in NSC, post office schemes; they double in seven years!? (By the way, HLL in the last seven years is up seven times!!) ?I am too lazy, I leave my money in term deposits with the bank!? (Certain to retire as a pauper!) ?I am clever, I keep deposits with finance companies and co-operative banks. I make upwards of 20%.? (He forgot to mention that a few of them are like CRB! Forget the returns you will not even get your principal!!) A very rare response would be: ?I invest in equities. I bought Infosys @ Rs500, Zee Telefilms @ Rs220?? (Anybody cares to do the sums for him?!) Equities, or shares as they are popularly known, have been an enigma for most people. A majority of the middle class in India considers it akin to gambling. A majority of the rest is fascinated by the volatility and the short-term money-making opportunities and misunderstand equities to be a ?get rich quick? scheme. There are very few people who understand that equities offer the highest returns in the long run, adjusted for inflation or even otherwise. Take the case of Nagesh... Nagesh has had a very conservative upbringing. However, he moved out of his home to pursue his higher studies and his eyes opened! He has been working with a leading MNC as a marketing manager. He has been wisely investing in shares for the last five years, relying on his broker?s advice after doing his own homework. On the other hand, his father worked all his life in a PSU and put all his savings in NSC and Life Insurance. He has retired today and has just realised that all his lifetime savings cannot help him lead a comfortable retired life. Nagesh is now trying to help his father out... Nagesh: Appa, even now it is not too late. You must invest a portion of your savings in equity. You are getting disheartened because you want to live off the meager interest earnings on your savings. If you put a portion of the money in, say HLL, your money will double in 3 years, quadruple in 5 years!! Appa, equities have the ?power of compounding that is unmatched?. Appa: Equity is very volatile. After you told me last time, I have been tracking the Sensex on Star News. It goes up two days then there is some political uncertainty and it falls. Sometimes it falls without any reason or otherwise goes up 15% in four days. I cannot handle it. At least here, my principal is safe and I get a fixed return. Nagesh: Appa, if you use the same Sensex as a benchmark, then the index was 1220 in September 1990 and currently trades at 4800 in September 1999, up four times in 9 years! Even if you had put in money at the height of the market frenzy in 1992, you would have still made money. The market benchmark is just an indication; the concept is to invest in specific good companies. Think Company, Appa, and don?t let the short-term market volatility scare you! In September 1990, HLL was trading at Rs115, while it trades at Rs2500 levels now! 22 times in 9 years!! Appa: Even then, why put my savings in risky equities? Understanding Equities Learning To Invest - In Equity Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 7: Valuing Equities Chapter 2: Understanding Equities Chapter 5: Capital Structure Chapter 3: Equity Risks Chapter 6: All about financial ratios
Equity, thy name is enigma
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Nagesh: An equally important thing to understand is: ?Why does one save?? One saves because the productive span for any human being is a small portion of one?s entire life. I may live for 80 years but I can only work between the ages of 24 and 60. Hence, it becomes important during our productive lives to earn surpluses and save them for the period when we can?t be productive and earn. Having said that, Appa, you would also recognise that it is important to retain the purchasing power of our savings. In other words, we all know that we used to purchase grains at Rs2 per kg 5 years back, while we pay Rs10 per kg for the same now. The price will keep on increasing as the population living off a fixed area of land increases. Hence, it is also important that whatever we save now at least fetches us an equal quantity when we retire...have I lost you? Appa: No, I was just thinking. You are right. I deposited Rs10,000 seven years back in NSC and I just got Rs20,000 now. Seven years back, I used to get vegetables for Rs25 and it used to last for a whole week and then we were four of us. Today, I buy vegetables for Rs100 and it barely lasts for a week though there are just the two of us! Nagesh: Exactly. That?s why people used to buy gold and land to protect their savings from inflation. However, those were the days when communities were small and agriculture was the only activity. As population grew, needs grew and there was a compelling need to improve efficiency. Hence, factories came up to exploit economies of scale. To cut a long story short, investment in productive assets is the best way of preserving savings and creating wealth. Equity is the most productive asset. Appa: What is the connection? Nagesh: Equities or shares represent ownership of businesses that own productive assets like plant & machinery and intellectual capital to produce more goods. On the other hand, when you put money in deposits or lend directly, the money ultimately finds its way to purchase productive assets as companies borrow to fund their business! Just like we save to take care of our retirement, productive assets are created to meet greater demand for goods in the future, because of increasing population and its ever increasing needs. Who ever borrows to fund the asset hopes to make more money on his equity than what he pays for on his borrowings. So, savings in deposits or any other fixed income instrument is sub-optimal! Hence, intuitively too, equity has to make lots more money in the long run than any deposits, because there will be no borrowings if the equity owner realises lesser money!! Appa: All that is fine. But some companies don?t do well? Nagesh: Obviously they are risky as certain businesses find the going tough. But collectively, they are not only very essential but very profitable. Hence, the returns on equity are always higher to compensate for the additional risk. Risk is a part and parcel of life. There are so many bus, rail and two wheeler accidents, but that doesn?t mean that we prefer to walk everywhere. Even if we decide to walk, we run the risk of being hit by another vehicle! One should only take care to invest in the right businesses, which have assets capable of earning good returns. Hence, these will have to be businesses that have a bright future. Nobody thinks of buying a bullock cart now!... The discussion went on for some time. Nagesh?s father was last spotted opening an account with a brokerage house. We checked with the broker and found out that he had made his first purchase of equity?200 shares of HLL?at the age of 62!
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Buying a stock is like owning a company. Puzzled? Learn the basics of learning to invest in stock market. Chapter 1: Basic Concepts Chapter 5: Capital Structure Chapter 3 Chapter 4: Chapter 2: Understanding Annual Report Equities Explained Chapter 6: All about financial ratios Chapter 7: Valuing Equities
Learning To Invest - In Equity
You've heard it before: nothing risked, nothing gained. But what is risk? Article 1: Khel risky hai | Sep 27 2002 Some risks pertain to the market as a whole, some to specific companies... Article 2: Taming the risk | Oct 8 2001 Risk is known to be a party pooper. We know that risk will always exist. Which is why we need t... Article 3: Risk: the time element | Sep 17 2001 How likely is it that you might trip and fall in the next half an hour? In the next two weeks?I... Article 4: A calculated risk | Jan 14 2002 Risk is a choice rather than fate. Equity risk premium is the "reward for holding a risky inves... Article 5: What is right risk premium? | Jan 21 2002 Weve understood the concept of risk premium. Let us now see if risk... Article 6: Chasing the elusive 'Risk Premium' | Sep 18 2000 Staring at "Equity Risk Premium" square in the face...
Chapter 3: Equity Risks
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Article 7: Graduating in Risk Premium | Jul 2 2002 Crack the link between "Beta" and "Risk Premium". Master the concept of CAPM with ease... Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page While reading through the past learning pieces, did you ever say to yourself: ?Such huge returns? Too good to be true. There must be a catch somewhere.? Or did Nagesh?s father?s apprehensions regarding market volatility and concerns over companies faring badly unsettle you? Did our reference to equity risk, ?no free lunch? and risk profile leave questions unanswered? We sure hope it did, because understanding risks associated with equities and learning how to manage them is the key to achieving higher returns from equities. Remember, the most important features of a fast car are the brakes and the steering wheel?not the accelerator! We begin our own humble attempt to understand this monster that can gobble up all our hard-earned returns! Why have equity prices fallen in the past?

Learning To Invest - In Equity Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 7: Valuing Equities Chapter 2: Understanding Equities Chapter 5: Capital Structure Chapter 3: Equity Risks Chapter 6: All about financial ratios
Equity Risks
Khel risky hai
Whenever governments have fallen; political instability (Top-of-the-mind recall) Inflation hitting double digits; rupee falling; interest rate hikes (the knowledgeable will tell you these are broad economic parameters that affect all businesses) A lot of people will tell you that wars have spooked the market?Gulf War, Kargil crisis, etc (country and lives are at stake.). Scams!! (Human greed knows no bounds). Bad management interested in making a quick buck themselves Company?s products bombed (Bad luck, bad strategy or bad marketing?). Lakshmi Machine Works suffers as textile mills are not doing well (a case of a specific sector going bad that wipes out even the best of companies). A chemical company?s plant caught fire destroying it completely (God save us!) A brilliant product but the company?s borrowings strangled the product before it saw the light of the day (Debt leads to death!)
So many of them, you ask? Let us see if we can classify them into broad categories. If you look at these reasons in detail, you realise that there are some factors that are within the company?s control or specific to the company?s business (bad management, products bombing, sector downslide, fire, borrowings?). The rest of the factors (politics, macroeconomic issues and wars) affect the market in general. OK, we seem to have got two watertight classifications for equity risk. One affects specific companies and sectors. Textbooks have various names for it??diversifiable risk?, ?unsystemic risk?, ?business risk?, ?company risk? and so on. The other set of risk affects the entire market??undiversifiable risk?, systemic risk?, ?market risk?..... The amazing power of classification! Suddenly, our big list of risks looks manageable. We just need to understand which basket they belong to! To get the classification right, let us delve a little deeper into the two groups. We will take up the ways and means of tackling these risks in our next session (lest we suffer from overload). Company risk: a closer look Though company risk is specific to the company, some risk factors that affect the business are within the control of the company. Corporate India is replete with instances of how a company could have controlled its future better.
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Real Value?s (the ?Ceasefire? company) ill-conceived foray into ?vacuumisers? is an example of strategy going haywire. There are hazar Indian promoters who have siphoned money from their listed companies?examples of bad management. Core Healthcare (earlier Core Parenterals) is another classic example of a company that had the right product but, in its urge to build mega plants, it borrowed beyond its means before creating a market?the rest is history (the company got into a debt trap, and the product became a commodity). All these risks can be avoided if proper homework is done to understand businesses and make a future looking call on their businesses. Only stock-picking skills can see you through this maze of risks. Now you know why good research analysts are so sought after! The other sets of risks that are business specific are beyond the control of the company. What can Madras Cements do if the cement market suddenly slumps as there is too much new capacity with no matching demand! What can TNPL do if demand for newsprint falls as more and more people take to reading newspapers on the Internet! (Not now! But it can happen 10 years down the line) What can Tisco do if Posco dumps a million tons of steel in the country (not literally!)! Of course there is something that these companies can do to rework their strategies, but it is time consuming. And you know our stock markets! The prices will get hammered with the first waft of bad news. In any case, if one were to diversify one?s holdings across various sectors and companies, the risks can get minimised to a certain extent. Risk diversification is another useful concept to understand, which we will take up next time. Market risk Company risk is still easy to contend with, but what do we do about market risks? Out of the number of factors affecting markets, our experience tells us that market declines under many of these factors are temporary and provide excellent buying opportunities for the patient investor who thinks and buys good companies (We love this kind of an investor or company) Market risk is a different animal altogether. Diversification does not help as all stocks get affected by these factors. But fret not, the native ingenuity of mankind has found solutions to this problem too, in the form of ?Futures? & ?Options?. We will be writing soon about the mechanisms behind such high-sounding terms and how you can use them (whenever they start here!)
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Equity Risks Learning To Invest - In Equity Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 7: Valuing Equities Chapter 2: Understanding Equities Chapter 5: Capital Structure Chapter 3: Equity Risks Chapter 6: All about financial ratios
Taming the risk

Welcome once again! Our preparation for the exciting journey into the adventurous world of equities has progressed to the next grade. In case you are joining us now, don?t lose heart. We will take you through a whirlwind tour of what we have learnt so far. For those of you who have been with us all through, it will be a good time to reflect on the key points. You will be better prepared to brave the adventure and emerge victorious. We began by understanding the necessity to invest for growth, the necessity to beat inflation and retire wealthy. Our adventure began the moment we discovered that equities are lucrative. Not exactly! No adventure can be successfully undertaken before understanding the basics. We figured out that the most important criteria to qualify for the journey is to be debt-free or, in simpler words, how much surplus we have after paying off all our obligations. We also understood a very important concept. Building of equity investments depends on two criteria: 1. Everybody can?t take the same level of excitement (Risk Profile) 2. Individual cash requirement (Liquidity Requirement) Then came the party pooper?Risk. The outside chance of losing instead of gaining. In our attempt to understand risk, we classified risk into ?Controllable Risks? (also called ?Company Risk? or ?Diversifiable Risk?) and ?Beyond Control Risks? (also called ?Market Risk? or ?Undiversifiable Risk?). Wake up! We know that ?risk? will always exist. Let us learn to tame it.We use a clich?o reinforce an age-old truth: ?Don?t put all your eggs in one basket!? Spread it around so that if one basket were to drop, only a few of your eggs break! Equally important is to decide: ?In which basket do I put my eggs in?? We will take this up in our next leg of preparation. Remember, we hope to make soldiers out of you! Let us understand our monster better?Equity Risk. Try answering this question below. For the uninitiated, ?Long? stands for a bought position in stock while ?Short? stands for a sold position in a stock that is not owned. Which of these options do you think is very risky? Which one is the least risky? 1. Long SAIL 2. Long SAIL & Long TISCO 3. Long SAIL & Long HLL 4. Long HLL, Long TISCO, Long ACC & Long Infosys Let us look at all these four choices? Choice #1-Long SAIL (our PSU steel company). I am exposed to company-specific risks (inefficient manufacturer, bureaucracy...). I am exposed to the steel cycle too (what if steel prices drop 5%?). To top it all I am exposed to the market risk (Vajpayee government?s fall takes the Sensex down 200 points. Want to know my SAIL price? It has hit the lower circuit!) Gosh! I am exposed to every conceivable risk. Choice #2 - Long TISCO & Long SAIL. Tricky hey! Two biggest players in steel. As far as company specific risks go, TISCO is a better bet then SAIL. So I am better off. Steel sector downtrend affects both of them. However, since TISCO is a more efficient producer, he will do better than SAIL. So I am better off. However, as far as market risks go, both of them get affected anyway. So I am indifferent. Adding it all up, Choice #2 is definitely better than Choice #1. We have learnt our first key learning. In choice #2 I had two stocks. I diversified. Voila! The risk reduced! So, diversification helps reduce risks! Choice #3- Long SAIL & Long HLL. SAIL is a steel company whereas HLL manufactures soaps, detergents? products that human beings will always use come rain or shine! These two companies are in different
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sectors. If the economy or steel sector does badly, I lose out on only one half of my investment! HLL is a well managed company, so I am better off. Hey, I am much better off than my earlier choice. I have split my risks between two unrelated companies and sectors. What about market risk? SAIL has a lot of sympathy with market movement whereas HLL is very stable (People can?t stop taking a bath just because the Sensex has been down for six months! Whereas people will stop buying cars and car companies will stop manufacturing and hence, steel companies will not be able to sell their steel!!) Choice #3 is excellent! We have learnt our next key learning: Equity risk is not additive! SAIL will have a certain risk on its own while HLL will have another one. But if we have the two of them together, then the risk of this basket will not be risk of SAIL plus risk of HLL. Remember, if SAIL is going down, HLL will not be as money flows to the safe stocks. Similarly, when the going is good, SAIL will outperform HLL. Choice #4 How all of us would give our right hand to own it! All these four stocks are leaders in their sectors. The sectors almost cover the entire spectrum of the market. At least two of them will be doing well. Any guesses on where it stands on our risk spectrum? Obviously, it is our first choice as it is the least risky. Another lesson: More widespread the selection of stocks, the better diversified and less risky a portfolio becomes. As the number of stocks increase, risk reduces. All these instances of diversification were able to bring the ?diversifiable risk? under leash. However, there is another kind of diversification that can take care of the more crazy ?market risk?! A combination of long and short positions!! Long HLL and Short SAIL. What have I achieved? Let us look at company risks. Since, I hold HLL I own the company risk whereas if SAIL goes bust because of a company-specific risk, I gain because I have already sold it. With respect to market risks, if the market goes down, SAIL goes down more than HLL so I don?t lose money at all! In short, by using this combination I have only taken company-specific risk. A risk that I understand and can control. These kind of combinations of long and short positions are used to mitigate market risks. Even the uncontrollable animal can be tamed! Market men call this ?Hedging?. ?Futures & Options?, which we will discuss later, facilitate this better. Now we know how diversification helps reduce risks. Did anyone bother to ask: ?What about returns?? Well, the clever ones among you would have figured out that by limiting our downside, we have parted with a bit of the upside! So there is a trade-off. Achieving the right balance between risks and returns is the key. Laws of nature apply here too??Strike the right balance?. We will try to take up optimisation or maximising returns for a unit of risk very soon.
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Risk: the time element

We all know that 'company' and 'market' risks are the hazards that any equity investor faces, right? Wrong. Risk has another dimension - that of time. Time plays a role that is often not very obvious to us in the stock market. To explain this facet of risk let me give you a simple example. How likely is it that you may trip and fall in the next one second? How likely is it that you might trip and fall in the next half an hour? How likely is it that you might trip and fall some time in the next five years? Get the point? You can say with 100% certainty that you will not trip in the next one second. You can also, perhaps with the same degree of certainty, say that you are unlikely to trip and fall in the next half an hour. But the degree of certainty would definitely reduce over a five-year time frame. And further still, over a 10-year period. That in other words, ladies and gentlemen, is the time element of risk. Risk increases with time Arguably, the time element of risk is very often part of company risk or market risk. But the reason we would like to focus on this element separately is that this is an element of risk that is not understood very well. Neither is it given the place of prominence that it deserves. This is particularly true of what we call 'growth' stocks. Stocks that you buy because you think that they will grow phenomenally over the next few years. 'Growth' investing has been the most popular and successful form of investing in recent years. Stocks from the technology, media, telecom and biotech sectors are prime examples of 'growth' stocks. These 'growth' stocks look expensive by conventional metrics - price-earning (P/E), price-book (P/B) and economic value (EV). But even after the recent meltdown in the past three months these stocks have handsomely rewarded investors who bought them 2-3 years ago. Despite, as we said, being overvalued based on conventional metrics even two years ago. In the words of the legendary investor and thinker Benjamin Graham: 'The successful purchase of growth stocks requires two rather obvious conditions - first, that their prospect of growth be realized; and, second, that the market has not already pretty well discounted these growth prospects.' Let us presume that the second condition (which continues to be debated to death) is not true - the market has not already discounted these growth prospects. So then, the only other condition that needs to be met is that the prospects of their growth need to be realised. This is not as simple as it seems And the obvious numbers that we look at do not tell the whole story. 'Infosys ka EPS agle saal 100 taka bad jayega' is the typical refrain that one gets to hear. Now we are no slaves to conventional metrics and are willing to be completely open minded. But is it okay to buy Infosys at a P/E of 180 only because it will grow at 100% in FY2001? The answer is a resounding NO. If buying Infosys at this price is to be a profitable proposition for you, then Infosys must grow at a scorching pace not just next year but for many years beyond that. The risk in owning Infosys comes from time. The risk is not whether it will grow at 100% next year, but whether it can grow at a compounded annual growth return (CAGR) of 50-60% over the next five years. Not an impossible task for a company with an impressive track record. But look at the size of the challenge. A 55% CAGR over the next five years means a forecast of Rs2500cr profit in FY2005. That is more than what big daddy Reliance makes by way of profits currently. At today's price (Rs7870) that would place Infosys at a reasonable P/E of 20 times its FY2005 estimates. That is a P/E that many companies (including Reliance) are not getting even on their FY2000 earnings currently. But that is another issue altogether What is relevant to you as a buyer of Infosys shares is that the company cannot afford to trip and fall
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anytime over the next five years. Now what degree of certainty would you place on that? Before you jump to any conclusions, it's not as impossible as it may seem (as our analysts are at pains to point out). After all, this same company reported a profit of just Rs13cr in FY1995. Would you have (in 1995) estimated that it would, in five years, grow to report a profit of Rs285cr? A twenty-fold jump! Our objective in highlighting Infosys is to underline the time element of risk. We are aware of the risk and have chosen to take it because we have confidence in the management of this company and believe that its strategy and business model will enable the company to get there. Those who took this risk in 1995 have been amply rewarded. Many people would dismiss this entire concept of time element of risk on the premise that if Infosys is going to double its profits this year, then so will its price and, hence, they can dump the share within six months and make money. To them we suggest that they consider the second condition listed by Benjamin Graham: '?that the market has not already pretty well discounted these growth prospects.' Who does not know by now that Infosys (profits) will grow by 70-80% this year? Anybody with access to a decent broker or CNBC knows that by now. By that count its growth prospects for this year are pretty well discounted. The reason why there is still money to be made from buying Infosys is that its growth prospects for the next five years are not discounted. Not everybody attaches a high degree of probability (or the same degree of probability) to Infosys reaching its destination in five years time. That is why those who take the risk (of time) will be amply rewarded. As an equity investor you must ask yourself this question every time you buy a stock. What is the time element of risk that I am taking? This is particularly true of buying 'growth' stocks.
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A calculated risk
Only those who risk going too far can possibly find out how far one can go - T.S.Eliot 'Investing is risky business' We have all come across this statutory warning or have learnt it the hard way while investing in the stock market. Let us take a step back to understand what is 'risk'. The word is commonly used to describe the chance of a loss. Chance: the Webster Dictionary defines this word as 'something that happens unpredictably without discernible human intention or observable cause' In other words, risk in the financial context stands for the uncertainties associated with future cash flows. We have learnt earlier how savings transform to 'Risk Capital'. We have taken a hard look at equity risks and figured out that 'Khel risky hai'. But did you know that 'Risk' owes its origin to the Italian word risicare that literally means 'to dare'? Risk as a verb is used to imply 'taking the chance'. In other words, as Peter Bernstein observes in the introduction to his magnum opus 'Against the Gods', '... risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about. And that story helps define what it means to be a human being...' If 'risk' is all about choices, it is time to know how to factor this in our investment decisions. Let us learn how these choices are made from the actions of Mr. Savvy Investor. Needless to say he is the smart guy who makes the smartest choices when it comes to investing. Mr. Savvy Investor has Rs1,00,000 to invest. He has two investment options. The first option is a government bond that pays an interest of 10% per annum for the next three years. The second option is investing in a particular stock. A leading analyst expects this stock to go up by just 2% in the first year as the company is still expanding capacity. But he expects the stock to gain 28% in the next two years. Mr. Savvy Investor fishes out his pocket calculator and gets down to business. The bond option is fairly easy to calculate. His Rs1,00,000 investment would be worth Rs1,30,000 in three years. In other words, it would fetch him a return of 30% in three years. He works out the returns for the second option. His investment would be worth Rs1,02,000 at the end of the first year. A gain of 28% over the next two years means that his investment would be worth Rs1,30,560. Thanks to the 'power of compounding. his 2% gain in the first year will earn a return too. In the end, he would earn a 30.56% return in three years. Two investment options with almost the same returns in three years. Which option does Mr. Savvy Investor choose? Our Mr. Savvy Investor chooses to invest in the government bond. It is easy to figure out why Mr. Savvy Investor has chosen the bond option. Though investing in the stock meant marginally higher returns. There were lots of uncertainties. Remember, investment in the stock is based on expectations, expectations of a leading analyst, in
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this case. On the other hand, the government bond gives a fixed return with no question of a default. What if the analyst got it all wrong? For all you know, a competitor might increase capacities and kill the market in the second year. Hence, the expected 28% appreciation might actually turn out to be a decline! As Murphy's law states 'If anything can go wrong, it will go wrong'. Hence, Mr. Savvy Investor does not even bat an eyelid while deciding to invest in the government bond. Let us now add a twist to the second investment option and see if it makes a difference to Mr. Savvy Investor's choice. The leading analyst expects the stock to go up by 12% this year as the company has finished expanding its capacity six months before time. He also expects the stock to gain 28% in the next two years. Mr. Savvy Investor does his calculations to figure out that his investment, in this case, would fetch a return of 43.4% in three years. A good 13.4% more than the government bond. Like earlier, the uncertainties still remain. However, since Mr. Savvy Investor earns 43.4%, he can still take the chance. If the stock fails to go up by 28% in the next two years and instead goes up by just 17%, he will still make a return of 31%! In other words, the higher return provides a margin of safety. Hence, the higher rate of return over the government bond for the same period makes Mr. Savvy Investor prefer the second option of investing in the stock. What made him go for the second option? The 13.4% extra return over the government bond. This 'extra return' that induces our Mr. Savvy Investor to choose the more uncertain investment option is called 'Risk Premium". A financial textbook will tell us that Risk premium is the 'reward for holding a risky investment rather than a risk-free investment. The extra return that the stock market or a stock must provide over the risk-free rate of return to compensate for the market risk is called "Equity Risk Premium". In case of Mr. Savvy Investor, the extra return of 13.4% over the risk-free 30% rate of return on the government bond defines his "equity risk premium" How do you determine 'equity risk premium'? What is the right premium to settle for? What is 'Beta'? More of this next time as we brace ourselves to risk the stock market and brave the uncertainties. As one great statistician wrote, "Humanity did not take control of society out of the realm of Divine Providence...to put it at the mercy of the laws of chance."
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What is right risk premium?

Risk is not always a bad thing What is the second thing that strikes your mind when you hear the word 'equity' or 'stock'? (If 'risk' is the first thing that flashes across your mind, then you seem to have had an overdose of emphasis on risk in our recent school write-ups. Maybe it is time for you to learn more about how stocks offer great returns over the long run and the 'power of compounding'.) If 'risk' is the second thing to take the dias, you are ready to take the next few steps in understanding this concept better. And just in case 'risk' was the last thing to chance upon your mind, we suggest that you start right at the beginning of these series. What is equity risk premium? Last time we understood that though risk is the chance of loss, it is equally a matter of choice. 'Equity risk premium' is the leveller that makes risky investment options attractive. Now it is time to put a finger on 'equity risk premium'. We saw that Mr Savvy Investor settled for investing in the stock since he expected to make 13.4% extra returns over the 30% return on government bonds in three years. In other words, equity risk premium is forward looking. If equity risk premium is forward looking and based on expectations, how do we know that we have settled for the right 'risk premium? Or how do we know that the 'risk premium' adequately compensates us in case the returns go against expectations? A theoretically applicable method is to look at returns associated with all possible situations. Then assign probabilities to these possibilities and get a fix on the 'expected' return. In the end, the expected return needs to be compared with the risk-free return to evaluate if the 'risk premium' is adequate enough. A little lost? Back to our good friend - Mr. Savvy Investor. Our thought experiment Small Cement Company (SCC), Efficient Cement Company (ECC) and Big Cement Company (BCC) are three cement companies. SCC has small capacity and hence its earnings improve dramatically after cement prices cross a threshold price. ECC, on the other hand, has a very efficient process and hence its earnings improve sharply with any rise in cement prices. The biggest of them all, BCC, is not so sensitive to cement prices, thanks to its size. In other words, BCC's bottom line moves in a more sober manner to the changes in cement prices. Time to make one simplistic assumption Let us assume that the earnings of these companies are sensitive to only cement prices. Hence, cement prices determine the returns from investing in these stocks. Mr. Savvy Investor needs to pick the best investment option from these three companies. Luckily, a cement expert and a stock market analyst have made life for our friend a little simple. The cement expert has assigned the following probabilities for the change in cement prices over last year. The stock market analyst has given his assessment of the expected returns from these three stocks for the respective changes in cement prices.
Event 5% decline
Probability 20%
Returns SCC -5% ECC 0% BCC 5%
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Flat 5% increase 10% increase
30% 40% 10%
+10% +25% +35%
+10% +20% +30%
+10% +15% +25%
Mr Savvy Investor had to make a wise choice with just these details. He calculated the average returns that he expected to make for each company. He had the probabilities associated with each return. Hence, all he had to do was multiply each probability with the associated return and add all of them together. For example, the average return that one can expect on SCC worked out to: 20%*-5%+30%*10%+40%*25%+10%*35% = 15.5%. This way, he calculated the expected returns for these three companies as follows:
SCC Expected Returns +15.5%
ECC +14%
BCC +12.5%
Do you think the choice was very easy for Mr Savvy Investor? After all, he just worked out that SCC has the highest expected returns. Think again, for our wise investor has chosen BCC over the others. To find out why, cast a glance upon the main table again. The returns on SCC can swing from -5% to 35%, an extremely volatile stock indeed, with returns moving in a range of 40% from -5% to 35%. On the other hand, ECC is little less volatile as its returns fluctuate within a band of 0% to 30% - a range of 30%. Finally, BCC is found to be a relatively steady stock. The worst case return on BCC is found to be 5% although the best case return, at 25%, is less than the returns of the other two. Anyway, this is a comparatively small range of 20% fluctuation in return. Factoring in volatility of return Mr Savvy Investor made another smart back of the envelope calculation. He divided the expected returns for each of these stocks by the range of possible returns. Look at what he got from his crude calculation...
SCC Exp Returns/Range 0.3875
ECC 0.467
BCC 0.625
In other words, Mr. Savvy Investor calculated his expected returns for every unit range of return that the stock could swing. A neat approximation to what the statisticians will call 'deviation from the mean'. BCC turned to have the highest return for every unit of risk. The answer became obvious to Mr. Savvy Investor- BCC was the best investment option. Of course, he might discover that the risk premium built into the 12.5% return from BCC' investment is not a good enough premium. But that is a different story altogether. A recap on this lesson We will revisit these calculations later. It is time now to take stock of what we have learned about 'equity risk premium' so far:

This premium is forward looking in nature, as it is based on 'expectation' of return. Expected returns could vary within a wide range. A higher range of return implies a higher gap between expected return and the actual return, thereby increasing the uncertainties associated with the return. We also understood that in case the range of returns from an investment in a stock is very large, then investing in the stock is more risky. However, this was a crude way of pinning the volatility of stock returns. After all the more likelihood of stock returns swinging from our expected returns, the more uncertain the actual returns we realise in the future. Look at our example, SCC returns are expected to be 15.5% but the eventual returns could swing any where from a -5% to 35% depending on how cement prices turn out. Statistically, the deviation from the expected return is a measure of the volatility of the stock returns. It is not enough to select the stock with the highest 'expected' return. It is important to select a stock that has a higher return per unit of risk.
Of course, this essentially explains the concept of 'equity risk premium'. The higher the volatility or uncertainty, the higher the risk premium sought by the investor. Getting the 'risk premium' right - the next step Now that we understand all these concepts, how do we get around the issue of obtaining a fix on this risk? After all, everybody invests based on expectations. How can we figure out today how much the returns will deviate from expectations in the future? Academicians have worked on evolving methods that help us approximate and get a better fix on these future uncertainties. Next time, we will grapple with the issue of getting a fix on 'risk' and demanding the right 'risk premium'.
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Chasing the elusive 'Risk Premium'

Welcome to the next leg of our 'Risk Premium' journey Having come so far in the lesson, one would assume that you have understood that the risk premium demanded by equity investors on their investment is forward-looking, as it is based on the expectation of returns. You have also understood that risk premium increases with higher volatility of expected returns. Hence, we saw our friend Mr Savvy Investor choose an investment option, based not just on expected returns but expected returns adjusted for the risk. So, take a deep breath and think back on what trait Mr Savvy Investor was displaying when he made the requisite calculations. He was avoiding risk! He was unwilling to take on additional risk unless he was compensated for taking that risk. Such risk avoiding behaviour is the cornerstone of rational investing. Textbooks state that a rational investor is risk averse, and that rational investors measure reward using expected return and risk calculated as variance. Risks borne by an equities investor Time to take a quick look at the broad classes of risks borne by an equity investor: As you figured out while reading "Taming the risks" , the risk borne by equity investors can be classified as two types - systemic risk, which is market risk and unsystemic risk, which is risk borne specific to a business. We also discovered that unsystemic risk can be reduced by diversifying investments across a basket of stocks representing various businesses. However, systemic risk is something that we have to live with. Can an investor expect compensation for bearing both market and business risks? If your answer is yes, you probably are asking for a little too much. Remember that, as an equity investor, you can spread your investments across a basket of stocks to reduce your business risk to zero. In fact, there are extensive studies that show that even a portfolio with eight stocks reduces unsystemic risk to zero. Hence, the only risk that an equity investor can demand a premium for is the systemic or market risk. Now that we know what type of risk you can demand compensation for, how do we go about measuring it? Simple, the risk premium for systemic risk needs to equal the risk premium for the market as a whole. After all systemic risk exists because of the pervasive influence of the market. But just the risk premium for the market is not enough What have we missed? Let's see... Assume that a new government came to power at the Centre and the Sensex went up by 8% in two days... 1. Would you think HLL, Infosys and HFCL all went up by 8% each? 2. If you think that they all went up by different percentages, then which one do you think went up the most? We have all seen that every stock posts different gains for the same gain in the Sensex. Stocks like HLL do not rise as fast as the market nor do they drop as fast. Infosys on the other hand posts gains higher than the market. HFCL, we are all well aware, moves sharply higher whenever the market moves higher while falling more sharply than the market in the downswings. In other words, the influence of the market forces is different on different stocks. Hence, we cannot just settle for the risk premium commanded by the market. We need to measure how the market affects a particular stock.
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The 'beta' factor 'Beta' measures the factor of influence of the market on a particular stock. Financial expert William Sharpe worked out a method for doing just this (calculating the beta of a stock). Many of you would have come across the concept of 'capital asset pricing model' or CAPM. CAPM makes a fundamental assumption that the historic volatility of stock prices will be mimicked in the future too. Next time, we will unravel how CAPM and beta help us get a fix on this elusive risk premium. Until then, I leave you with a thought to ponder: Do you think a high beta stock should have a higher risk premium or a lower risk premium?
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Graduating in Risk Premium

In case you have reached this vantage point after having understood the basics of 'risk premium', we offer you our hearty congratulations on having made such outstanding progress! Now, picking up the thread from where we left off, investors get compensated only for the market risk that they bear. Market risk is the only risk that cannot be reduced through diversification in your portfolio (by including a set of stocks from different businesses), like business risk can. However, the influence of the market varies for various stocks. Some stock movements are exaggerated compared with market movements while others are subdued. We understood last time that the 'beta' of a stock measures this relative movement of a stock vis-?is the market. Hence, 'beta' measures the tendency of the stock to participate in the market movement. Let's work this out using an example... Hyper Ltd., Tracker Ltd. and Sober Ltd. are three stocks that trade in the stock market of Shareland. Sharex is the stock market index in Shareland. Hyper has a beta of 1.3 while Tracker has a beta of 1. On the other hand, Sober has a beta of 0.7. First stop, what do these values mean? Hyper's beta value of 1.3 indicates that it is far more sensitive to market movements than Tracker and Sober. In other words, if the market as measured by Sharex goes up by 10%, Hyper will go up by 13%. Tracker will go up as much as the market, i.e. 10%, while Sober gains a mere 7% in relation to the market.
Who commands the lower risk premium? After having come so far in the lesson, we expect that you will flip this situation to its negative face and look at the situation when the stock market in Shareland drops by 10%. In this case, Hyper drops the most (by 13%) as it has a higher beta of 1.3. Since Tracker has a beta of 1, it drops by 10%, the same as the market. On the other hand, Sober drops by a mere 7%. A higher beta means higher risk and hence a stock with higher risk needs to command a higher 'risk premium'. And obviously, since Hyper reacts in a manner true to its name for every drop/gain in the market, it is the riskiest stock and should command the highest premium, followed by Tracker with Sober being the least risk option of the three. Moving on to CAPM So if the risk premium commanded by the stock market is x%, then the risk premium that investors should demand for a particular stock is beta times x%. CAPM states that the expected return on a stock is the sum of a `risk-free rate' and `stock beta times market risk premium'. This, in essence, is the capital asset pricing model (CAPM). After all, why should anyone expect to earn more by investing in one stock as opposed to another? You need to be compensated for doing badly when times are bad. The stock that is wont to do badly just when you need money in trying times is a stock you should hate, and there had better be some redeeming virtue or else who would want to hold it?
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How is beta calculated? Oh, we are not going to give you some longwinded formula. After all these days, you do not need to know how a computer works to actually use one. So, we shall never trouble you with formulae, but just explain the concept. An analyst calculating the beta of a stock obtains the historical returns of that stock over a period and then compares them using 'linear regression' to the returns on the index. It is just enough for most of us to know that linear regression is a statistical tool for estimating beta. Some pertinent questions to ask at this stage Q: Is the beta of a stock constant? A: The beta of a stock can change over time as the stock's characteristics transform. For example, a stock moving from the B1 group to the A group sometime back would have changed the beta of the stock. After all, the underlying liquidity of the stock would have changed as A group stocks have this carry forward mechanism that attracts a whole host of speculators. Q: Can a low beta stock be more volatile than a high beta stock? A: Interestingly, a low beta stock could be more volatile than a high beta stock. Remember, the beta measures only the systemic risk or the influence of the market on the stock whereas a stock on its own might have a very high unsystemic risk because of the risk associated with the company's business. Wrapping up today's spoils The key insight of the capital asset pricing model is that higher expected returns go with the greater risk of doing badly in bad times. Beta is a measure of a stock's tendency to move with the market. Stocks with high betas tend to do worse in market downturns than those with low betas. Our advice: If your heart has a high beta level, invest in a stock that has a low beta!
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Buying a stock is like owning a company. Puzzled? Learn the basics of learning to invest in stock market. Chapter 1: Basic Concepts Chapter 5: Capital Structure Chapter 4 Chapter Chapter 2: 3: Understanding Equity Equities Risks Chapter 6: All about financial ratios Chapter 7: Valuing Equities
Your essential guide to interpreting a companys report card Article 1: Back to basics | Jul 5 2002 Remember that booklet called Annual Report your company sends you every year? Article 2: The business snapshot | Feb 10 2003 Balance sheet is a snapshot of what a co. owes and owns. Article 3: Why read an annual report? | Jul 12 2002 There are some interesting and important fine prints in the Annual Report. It pays to read them. Article 4: ignore | May 11 2001 As always there is more than meets the eye.Here is a simple way to discern the income statement... Article 5: ignore | May 17 2001 Is depreciation a cash inflow? Is depreciation a necessary expense? The answers to these questi... Article 6: On depreciation | Jul 19 2002 Is depreciation a cash inflow? Is it a necessary expense? Follow this link for answers. Article 7: P&L in depth | Jul 16 2002 Here's an easy way to discern the income statement to know what is the true income of a business.
Chapter 4: Annual Report Explained
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Annual Report Explained Learning To Invest - In Equity Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 7: Valuing Equities Chapter 2: Understanding Equities Chapter 5: Capital Structure Chapter 3: Equity Risks Chapter 6: All about financial ratios
Back to basics
The profit & loss account Introduction If you own shares, you'll remember that the company sends you a booklet called an annual report just before the annual general meeting. Most of the time, all you've done is admired the glossy pictures before adding it to the pile of newspapers for the raddiwala. That's a pity, because a company's annual report can be a great source of information, helping you to decide whether to stay invested in the company. At the very least, it'll help you ask some tough questions to the management at the AGM. We know the problem. You'll be thinking that's a lot of unreadable stuff! Not to worry, accountants are in business by making it difficult for ordinary people to understand accounts! All of us can learn to read accounts. We'll show you how. The profit & loss account At the heart of the annual report is the Profit & Loss Account. Accountants call it the P&L account to show familiarity, as well as to make it difficult for ordinary people to understand what they're talking about. No company can exist for long by continuously making losses, and the P&L account shows the extent of profit or loss made by the company in a particular year. To illustrate, let's take the Reliance Industries annual report for 1998-99.
1998-99 Rs. INCOME Sales Other Income Variation in Stock 14,553.26 607.55 (152.43) 15,008.38 EXPENDITURE Purchases Manufacturing and Other Expenses 190.32 11,500.52 Rs.
1997-98 Rs. Rs.
13,403.78 335.60 368.28 14,107.66
14.19 11,206.93
Interest Depreciation Less : Transfered from General Reserve (Refer Note 3, Schedule 'O'){ Profit Before the year Provision for the year 1,776.66 921.62
728.81 1,460.27 855.04 13,274.69 1,733.69 30.00 792.95
503.55
667.32 12,391.99 1,715.67 63.00
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Profit for the year Add:Taxation for the earlier years Balance brought forward from last year Investment Allowance(utilised) Reserve written back Amount available for Appropriation APPROPRIATIONS Debenture Redemption Reserve General Reserve Interim Dividend Proposed Dividend Tax on Dividend Balance carried to Balance Sheet Significant Accounting Policies Notes on Accounts 204.50 1000.0 23.39 350.16 40.86
1,703.69 1,047.89 2,751.58
1,652.67 (85.67) 662.79 36.00 2,265.79
64.47 752.65 10.33 326.81 1,618.91 1,132.67 63.64 1,217.90 1,047.89
You'll notice there are two main heads - income and expenditure. Simply put, the difference between the two is the profit (if income exceeds expenditure) or loss (if expenditure exceeds income). And losses, as you know, are bad. Income The total income is broken down into several heads-sales, other income, and variation in stock. Obviously, a company's sales will be its main source of income, so that item doesn't need much explaining. A source of confusion can be the fact that sales are sometimes called gross sales and at other times net sales. The difference is the amount of excise duty paid, and net sales is merely gross sales less excise duty. Net sales is a better indicator of how much the company is selling, because the excise duty goes to the government. Clearly, higher sales help the company earn higher profits. "Other income" is accountantspeak for all those items of income which do not relate directly to the company's sales. This could include dividends and interest received by the company from its investments, the profit on sale of investments or assets, sale of scrap and other such items. Some companies put service income, like money earned by repairing or servicing, in this category. Basically, the thing to remember is that other income is very often, but not necessarily, income from activities distinct from the company's main activity. Sometimes such other income is one-off in nature, such as the profit from selling assets. So if you want to predict the company's future income, you'll have to leave out this kind of one-off income. The third item, variation in stock, reflects the fact that a company always carries some inventory, which is nothing but unsold stock on a particular date. The company has already incurred some expenditure in producing this inventory, which is reflected in the expenses part of the P&L account. So the value of the closing stock should also be included to give the correct picture of the profit. However, from this closing stock the value of the stock at the beginning of the accounting period must be subtracted, since that was included as closing stock during the previous accounting period. That sounds complicated, but just remember that the variation in stock is actually nothing but closing stock less opening stock of finished goods and stocks in process. Why not raw material stocks? Raw material stocks are not included here because there is an item "raw material consumption" in the expenditure section of the P&L account. Expenditure The expenditure part of the P&L obviously has purchases and manufacturing expenses. In fact, all the costs that go into making the things the company sells. But that's not all. Interest costs incurred on the company's debts are also included here. Further, there's an item known as depreciation, which is nothing but a notional estimate of the wear and tear of the equipment used by the company. The logic is that a company needs to set aside a sum annually so that it can buy new machinery when it is needed. Clearly, keeping costs in check will add to the bottomline. You'll notice that there's something known as schedules against the items in the P&L account. These are nothing but more detailed break-ups of these items. For instance, in the RIL P&L account, schedule L gives details of all the manufacturing expenses, such as salaries and wages, sales and distribution expenses, expenses on power, fuel, and administrative expenses like rent, insurance, etc. Profit and EPS Deducting expenditure from income gives the profit before tax. When the amount set aside by the company for tax purposes is deducted, we get the all-important net profit figure. Adding the balance brought forward in the account last year, we get the amount available for appropriation, which is nothing but the way the profit is divided. One chunk is paid to equity shareholders as dividend, one part goes towards paying dividend on preference shares, while the rest goes to statutorily required reserves, such as the reserve for redeeming debentures, and to the general reserve, which bolsters the company's net worth, or the amount of shareholder's funds. A last word about EPS, which is earnings per share. This is a figure analysts love to talk about. EPS is calculated by dividing net profit by the number of shares allotted by the company. It shows how much each share of the company has earned during the year.
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Also important is to check out the trends, by comparing last year's figures with those of the current year. Trends are important because they show the way the company is going. For instance, a company may still be earning profits, but the amount gets smaller and smaller each year. Nobody in his right mind would invest in such a company. That wraps up the basics of the P&L account. Investors can use this information not only to find a company's earnings, but also how it has arrived at these earnings. Did sales increase? Were expenses kept in check? Was interest expenditure too high? The answers to these questions will be provided by reading the P&L account.
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The business snapshot

Now that you've mastered the mysteries of the Profit & Loss Account, let's move on to the Balance Sheet. This gives you a picture of the size of the company's assets and liabilities, and the sources and uses of the company's funds Unlike the P&L account, which shows the profit or loss a firm has incurred over a period of time, the balance sheet is a snapshot of the firm at A POINT OF TIME. As on a particular date, the last date of the accounting period, the assets and liabilities of the firm are all added up and presented in the balance sheet. The capital and reserves are added to the liabilities side to balance the two sides. In other words, Capital + Liabilities = Assets. To illustrate, let us take the Balance Sheet of Reliance Industries.
As at 31st March 1999 Rs. SOURCES OF FUNDS : Shareholders Funds Share Capital - Equity Share Capital - Preference Reserves and Surplus Securitisation/Advance Against Future Recievables Loan Funds Secured Loans Unsecured Loans 5,477.64 5,207.65 10,685.29 TOTAL APPLICATION OF FUNDS: Fixed Assets Gross Block Less:Depreciation Net Block Capital Work-in-Progress 18,650.33 6,691.93 11,958.40 3,437.83 15,396.23 Investments Current Assets, Loans and Advances Current Assets Interest Accrued on Investments 25.61 4,294.59 24,019.65 933.39 252.95 11,183.00 12,369.34 965.02 Rs.
As at 31st March,1998 Rs. Rs.
931.90 187.95 10,862.75 11,982.60 300 2,736.78 5,510.55 8,247.33 20,529.93
17,848.33 4,944.47 12,903.86 2,069.43 14,973.29 4,282.33
21.07
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Inventories Sundry Debtors Cash and Bank Balances Loans and Advances Less: Current Liabilities and Provisions Current Liabilities Provisions Net Current Assets TOTAL Significant Accounting Policies Notes on Accounts
1,408.61 457.10 4,897.60 6,788.92 1,676.26 8,465.18
1,343.96 642.72 2,133.51 4,141.26 991.05 5,132.31
3,591.98 544.37 4,136.35 4,328.83 24,091.65
3,382.01 475.99 3,858.00 1,274.31 20,529.93
You'll notice it's divided into two broad sections- Sources of Funds and Application of Funds. Sources of funds What are the sources of funds? Obviously share capital is one of them. In the Reliance balance sheet, there are two types of share capital-- equity and preference. Equity shares are ordinary shares. Preference shares, on the other hand, are so called because they get preferential treatment when it comes to paying dividend. Preference shareholders are paid a fixed dividend, unlike ordinary shareholders, whose dividends vary according to how well the company has performed. However, preference shareholders, because they opt for the security of fixed dividend payments also forgo capital appreciation -their shares are typically redeemed at a fixed price (often no different what they paid for it). Profits retained by the business over the years are also a source of funds. These are included under the head "Reserves and Surplus". Loans, secured and unsecured, constitute the other source of funds. Secured loans are those in which the lender has a charge on the company's assets as security, while unsecured loans are those where there is no security, for example fixed deposits from the public. There's yet another source of funds. You'll find, towards the bottom of the balance sheet, an item called Current Liabilities and Provisions, which are deducted from Current Assets. Current Liabilities are things like Sundry Creditors, or those to whom the company owes money. In other words, you owe someone money, but you haven't paid him yet. So he becomes a source of funds. The other item, Provisions, is a bit trickier. These are sums set aside but payments have not been made. In other words, you need to pay income tax, wealth tax, dividend, leave encashment etc, and make provisions for them, but because you haven't yet paid these sums, they become a source of funds. Uses of funds Now we come to the applications side of the balance sheet. Here we have the uses to which all those funds, which have been sourced, have been put. There are two broad classifications--fixed assets and current assets. Fixed assets are things like plant and machinery. Total depreciation on these assets (see article on P&L account) is deducted from gross assets to arrive at net assets or net block. To that is added capital work-in-progress, that is, the projects going on at the balance sheet date. Investments in stocks or bonds are another way in which funds can be used. And lastly we have current assets, so called because they form part of the working capital cycle which transforms raw materials to finished goods. Current assets consist of inventory, people who owe the company (sundry debtors) and cash and bank balances. Loans and advances given to others is also a use for funds. How do you use this information? Now you have all this information about where the company has got its money from and how it has used it. But what use is it? You'll notice there are two columns in the balance sheet, with the previous year's figure also being given. Comparing the two sets of figures leads to some insights. For instance, in the Reliance balance sheet, the amount of secured loans has gone up from Rs2736cr to Rs5477cr. How did it use this money? The balance sheet shows that part of it went towards increasing gross block, part towards the higher capital work-in-progress a bit on inventories and a large part was held in cash and bank balances. You can make a similar analysis for every source and use of funds, checking out how funds were sourced and how it was spent during the year. For instance, if a company siphons out money by giving loans to associate companies, the balance sheet will tell that to you. A snapshot as on a particular date One important caveat. The balance sheet is a snapshot, as on a particular date. For instance, if you had checked the balance sheet a few days earlier, the cash and bank balances may not have been so high. Or a company may have repaid a loan just for a few days to show lower indebtedness as on a particular date. Doing up the balance sheet in this fashion is known as window dressing. So now that you can read a balance sheet, keep a pinch of salt handy.
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Why read an annual report?

Now that you've acquired the MBS degree (Master of the Balance sheet), you need to turn your attention to post-MBS studies. A company's annual report has reams of matter apart from the actual balance sheet and Profit & Loss figures, much of which could aid you in forming an opinion about the company. The Auditor's Report & the Notes to the Accounts Let's start with the Auditor's Report and the "Notes to the Accounts." The Auditor's Report will tell you what the auditor thinks about how the accounts have been drawn up. If he thinks that some accounting treatment is a bit dicey, and would affect the profits, he makes what is called a qualification to the accounts. In plain words, what he's doing is drawing your attention to the fact that the profit would have been different if the accounts had not been massaged. Usually, the auditor also tells you what impact the faulty accounting policy has on the firm's profits. The Notes to the Accounts contain some fine print that is well worth studying. For instance, the notes to Reliance Industries' accounts point out that inter-divisional sales of Rs3929cr are included in the company's sales figure. Inter-divisional transfers are sales between one division of the company to another. This amount, therefore, should not be included in the total sales figure. Or take another example. The Notes point out that RIL has changed its method of depreciation, with the result that the profit for the year has been understated. So if you didn't look at the Notes, you could be misled. Also included is quantitative information such as installed capacity, its utilisation, volumes sold etc. This will enable you to find out whether an increase in sales, for example, is due merely to higher prices, or to increase in volume of goods sold. Since the quantities of products produced are given, you will be able to get information about the trends in volumes of the different products. Spare a glance at the figures for imports and the foreign exchange earned. That'll enable you to gauge the impact, for instance, of a depreciation in the currency. The Cash Flow Statement The cash flow statement reconciles the opening balance of cash (and money in the bank) with the closing balance. It shows the effect on cash of the various transactions. Since profit is often dependent upon the accounting policies you adopt, the cash flow statement is a more transparent way of showing a company's operations than the P&L account. It provides additional data. For instance, while the change in the debt outstanding can be gleaned from the balance sheet, the cash flow statement will tell you how much of borrowings have been repaid and how much fresh borrowing has been resorted to. The cash generated from operations is an important indicator. If that figure is negative, it means that cash is being sourced from external sources to fund existing operations. That's certainly not sustainable in the long run. Chairman's Communication and Director's Report This is sometimes a mere PR exercise, but it could also be a source of insight into a company's strategy. An example would be Subhash Chandra's vision for Zee, which clearly charts out the way he wants the group to grow. The Directors' Report and, in some cases, the Management Discussion and Analysis, sets out the management's view of the operations of the company during the year. In a multi-divisional company, the performance of the various divisions are analysed in some detail. This would enable you to know which businesses are doing well and which not so well. Reconciliation with US GAAP Thee days, with an eye on the ADR market, many companies have started reconciling their accounts with the accounts according to the US generally accepted accounting principles (GAAP). For Reliance Industries, you will notice that the profit under US GAAP is much lower than the profit under Indian accounting norms. That's because of deferred tax. There is sometimes a difference between the year in which a transaction affects taxable income and the year in which it enters into pre-tax income. For instance, higher depreciation is permitted under tax laws as compared to the Companies Act. Over time, however, such differences are ironed out. The benefits of higher depreciation, for instance, are lost over a period of time. So unless accounting is made for deferred taxes, there could be sudden shock in the year when the tax shelter is
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withdrawn. Accounting for deferred tax smoothens out such fluctuations. Now that you've progressed to the stage where you understand the concept behind deferred tax accounting, you can award yourself the title" Doctor of the Annual Report".
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by Ashok Kanetkar Ashok Kanetkar is a retired executive with senior-level experience at several companies, most recently Cummins India. Apart from his experience of the corporate sector as well as the engineering industry - he is an articulate and dedicated student of Graham, Buffet and other investment gurus.
This article suggests a method of rewriting the income statement for gaining clarity regarding the performance of a company. Metaphorically speaking the format suggested will show whether the company is gaining in muscle or is just adding flab. Some financial terms have found a permanent place in every day usage. 'Bottom line' is one such term. A little later the term 'Top line' also started gaining in currency. This is but natural because if there is a bottom line, general expectation is that there should be a top line too. These lines, top and bottom, appear in the income statement of the annual report. In the income statement (also called a Profit and Loss account or simply the P & L account) the bottom line refers to the net profit made for the period under consideration and the top line refers to sales income. Analysis of an income statement starts from the top line, the total sales. It is here that an analyst has to make changes and clarify some of his assumptions. This is necessary because the main objective should always remain in view, which is to gain greater clarity and also to seek easy means of comparison between two or more companies. Generally, in the case of finding investment potential, the objective would be to find the 'true' income of the company. By 'true' we mean that income which has come out of the declared main activity of the company. Though we shall not totally overlook income from other sources, our main aim is to find out how the company is performing in its avowed activity. So, we shall initially overlook the 'other income' and then make adjustments for any other income, which is not of a recurring nature. Reasons for ascertaining the true income are simple and also logical. Company's profits essentially should come from its main activity. What it earns out of its investment activity is the butter and jam on the bread and not a reward for its own toil and sweat. We are interested in finding out how the company is faring in the existing market on the basis of its product. In other words how it is earning the bread without which the butter and jam are of little value. A downward trend in the income from main activity is a clear indication of trouble in the near future. If the trend continues, chances are that other income will also start sliding leading to further trouble. One more assumption is that past performance is a fair indicator for projecting future earnings. Theoretically, from investment point of view, this may not sound right because while investing in shares we are interested in the future and no one can really predict what the future has in store. Experience, however, suggests that matured companies do not deviate too much from the past. The relationship between income and different expenditure heads shows a relatively stable pattern and a major deviation therefore in any year can easily stand out. Circumstances in the past which led to record performance in either direction become apparent and if similar circumstances are expected to arise again in the future, projections become that much simpler and realistic. With the above logic a format for rewriting the income statement is
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suggested. The example taken is of Great Eastern Shipping and the idea is developed in two steps. The first step leads to a broad analysis and finer points are seen in the second step. In the first step the other income is taken out and all expenses are deducted from the operating income. The other income is then added back. This method readily shows how much dependent the
company is on its other income.
In the second step the operating and other income is further investigated to take out non-recurring items that are in the form of one time windfall or such items that are not likely to appear in future statements. Step 1. Rewritten Income statement of GE Shipping. Figures in Rs. Million.
Income from Operations Less Expenditure Operating Profit Less Interest PBDT Less Depreciation Less Provisions Operating PBT Add Other Income PBT as on P & L Acc. Less provision for tax PAT for the year
Mar 2000 9625.9 6260.3 3365.6 608.1 2757.5 1811.7 0.0 945.8 318.7 1264.5 160.0 1104.5
Mar 99 9295.0 5988.9 3306.1 578.2 2727.9 1647.0 50.0 1030.9 513.5 1544.4 280.0 1264.4
Mar 98 9150.5 5435.2 3715.3 650.4 3064.9 1558.1 85.0 1421.8 490.4 1912.2 270.0 1642.2
Note: We advise that in case manufacturing units where sales are inclusive of excise duty, it is a good practice to deduct excise duty from operating income as well as from expenditure to get a proper feel.
In the case of GE Shipping, by separating the other income from the total income, we find that the company has marginally improved its efficiency. This is not the picture that emerges from a look at the PBT and PAT, which show a continuing slide despite a continuing rise in operating income. Thus, though the slide continues as far as bottom line is concerned, the company has managed to arrest it at the operating level. This, for an analyst, is a very important finding because it tells him that things are not as bad as they look. The above figures also show, with greater ease, that the real culprits are interest, depreciation and lower other income. A view may be taken that higher depreciation is on account of higher investment in plant and equipment that was financed by liquidating some of the investments and additional borrowings, which in turn have given rise to higher interest. It may gladden the heart of the analyst to know that the company is investing in new equipment and is willing to pay the higher depreciation though it may somewhat mar the bottom line. When the market conditions improve the company may be in a position to take full advantage of the added equipment. This view, however, will have to be confirmed by going into further details. A 3.5% increase in operating income has resulted in an increase of 1.8% in operating profit, which is much better than the previous year where an increase in operating income of 1.5% had actually resulted in a decline of 11% in the operating profits. An important trend reversal has taken place here. The next step calls for a slightly detailed study of the income schedules to find out the non-recurring type of income or income from past events. Examples of such items are settlement of old claims, refund of excess income tax, income through renegotiations, recovery of some bad debts which were earlier written off and any other such items. It is true that generally such items are small in amount compared to the main income yet an analyst has to make sure that any distortions due to oversight are straightened out. Occasionally we also find some windfall items. A company may decide to sell its holding in other affiliated company during a particular year. The profit from sale of such an investment is definitely a non-recurring type if it exceeds average of earlier years. One example that comes readily to mind is of Kirloskar Oil Engines Limited when it sold a part of its holding in Kirloskar Cummins Limited. For income from earlier years it is a good practice to deduct it from the year in which it is reported and add it to the year to which it pertains. For windfall income it is better if it is deducted from the single year but maintained in the long-term analysis. Coming back to Great Eastern Shipping we find two items of the type mentioned above in the annual report for year 1999-2000. The schedule for other income shows Rs. 7 Million as 'Doubtful advances written off in earlier year now recovered' and Rs. 42.5 Million as 'Provision for diminution in value of long term investment written back'. As per our discussions, therefore, Rs.49.5 Million should be deducted from the income of 99-2000 and added to the income of 98-99. The corrected values should therefore appear as given below
Operating PBT Add O/Income (Adjusted) Total PBT
Mar 2000 945.8 269.2 1215.0
Mar 99 1030.9 563.0 1593.9
Mar 98 1421.8 490.4 1912.2
Please note that in this case the changes are in the other income only and therefore the operating PBT is left unchanged.
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A securities analyst has to find out the company's ability to generate sales and retain maximum amount out of it. What it earns out of its own muscle power is what is of main interest and the rest is to be treated as secondary. The above format allows the analyst to study this ability. If one considers Sales as the driving pump for the financial system then it is worth our while to know how much is pure water and how much is air out of all that is pumped. Both are useful but one is more important than the other is.
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Copyright 2000 Sharekhan.com & SSKI Investor Services Pvt. Ltd. All Rights Reserved. The views contained in this column are that of the author. Sharekhan.com may or may not concur with the views expressed by the author. We do not represent that it is accurate or complete and it should not be relied upon as such.
Copyright 2003 Sharekhan.com & SSKI Investor Services Pvt. Ltd. All Rights Reserved.
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At 95% of American businesses, capital expenditures that over time roughly approximate depreciation are a necessity and are every bit as real an expense as labor or utility costs. Even a high school dropout knows that to finance a car he must have income that covers not only interest and operating expenses, but also realistically-calculated depreciation. He would be laughed out of the bank if he started talking about EBDIT -- Warren Buffet (1989 letter to shareholders)
Depreciation is an expense but it is not a cash expense. It reduces the profit for the year but not the cash inflow. This apparent anomaly gives depreciation a mysterious aura in the balance sheet and profit and loss account. The mystery however gets resolved if it is understood that depreciation is a gradual allocation of expense incurred in acquiring fixed assets spread over a number of years. The term fixed assets is used to describe long-lived assets acquired for use in the operation of the business and not intended for resale to customers. Major categories of fixed assets are tangible and intangible. Examples of tangible assets are land, building, machinery, furniture, vehicles etc. Goodwill, brand value, trademarks, patents etc are the intangible assets. The term intangible is used to describe an asset lacking in physical substance. Depreciation is mainly applicable to tangible fixed assets. Reader should note that companies generally have a policy about depreciable fixed asset. Thus a pencil sharpener worth five rupees, though technically a fixed asset, is not treated as such and is treated as revenue expenditure for its full value but a building worth a few million rupees is treated as a fixed asset to be depreciated over the years. Treatment of pencil sharpener as revenue expenditure is mainly for accounting convenience. Fixed assets, with the exception of land, are of use to a company for only a limited number of years, and the cost of each fixed asset is allocated as an expense during the years it is used. The term 'Depreciation' is used to describe this gradual conversion of the cost of a plant asset into expense. A convenient way of understanding this is to think of fixed assets as a bundle of services to be received by the owner over a number of years and payment is to be made for the service received during the year at the end of the year. The committee on Accounting Procedures of the American Institute of Certified Public Accountants has very lucidly described the concept of depreciation as follows:
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The cost of productive facility is one of the costs of the services it renders during its useful economic life. Generally accepted accounting principles require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility. This procedure is known as depreciation accounting, a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit in a systematic and rational manner. It is a process of allocation, not of valuation.
Depreciation is not a process of valuation. The term residual value or written down value is slightly misleading. It is really the residual amount of the original cost, which is yet to be allocated. In actual reality also the residual cost rarely, or almost never, is equal to the value of the asset in the market. This aspect can be understood by considering the example of the building. The accountant will continue to allocate the cost every year and at some point the residual cost will either become zero or very near to zero, depending upon the method of calculating depreciation, but if the company decided to sell the building the amount it would receive will be as per the market demand for that building. We should now see the two basic causes of depreciation and then proceed to the methods of calculating it. The two causes are physical deterioration and obsolescence. Physical deterioration occurs from use and exposure to atmosphere. This is simple to understand. A car used for a year is definitely not the same as it was when bought. Similarly a machine after some use is not the same as it was when new. Some wear and tear is inevitable. A time will thus come when after some years the car or the machine ceases to give any useful output. This wear and tear is the expense or the depreciation and this number of years is known as the useful life of the asset. Obsolescence means the process of becoming out of date or obsolete. Computers are a good example of equipment going out of date very fast. Technology in this area is making such rapid progress that what was efficient a couple of years ago is no longer so. Machines with Windows 95 became outdated when Windows 98 operating system arrived. Size of the RAM becomes outdated almost every year. The useful life of these machines, thus, is much shorter compared to other types of machines or buildings and therefore the amount of depreciation is also greater. In India two main methods of calculating the depreciation are prevalent. One is called 'Straight Line Method (SLM)' and the other is called 'Written Down value (WDV)' method. In SLM the initial cost is distributed equally over the useful life. Thus every year an equal amount is allocated as an expense till the cost of the asset is fully recovered. Take the example of a car. If a car is purchased for Rs. 100,000 and the useful life of the car is decided to be five years, then every year Rs. 20,000 are allocated as an expense in the profit and Loss account on account of depreciation of the car. At the end of the fifth year the cost of the car will have been fully recovered. The rate of depreciation in this case is 20% per year. In mathematical terms this will appear as, SLM Residual cost = IC{1- DY/100}, where: IC = Initial cost D = Rate of depreciation in percentage Y = Number of years. In the WDV method the rate of depreciation is the key and depreciation is calculated at that rate which is then applied to the residual cost every year. In our example of the car, for the same rate of depreciation i.e. 20%, the residual cost after the first year will be Rs. 80,000 and after the second year it will be Rs.64000 and so on. This principle ensures that the value of the car will never become zero. This is understandable because even the car fit for the scrap yard will have some value. In mathematical terms this can be expressed as,
WDV Residual cost
IC (1-D/100)^Y ;
(Symbols are same as those for SLM equation) Though mathematically a possibility exists of residual cost becoming zero if rate of depreciation is 100%, this is against the basic concept and hence overlooked. The important point to remember is that in SLM the residual cost can become zero while it can never become zero in WDV. Please note that the rate of depreciation mentioned above is imaginary. Companies have to observe rules about rate of depreciation as well as the method of calculating depreciation. In the schedule explaining accounting policies in an annual report companies disclose the method used for different assets. Since every year some expense is allocated as depreciation, it is natural that it should be deducted from the Sales revenue along with other expenses like manufacturing expenses and interest etc. Therefore we see it appearing in the profit and loss account and why it reduces the profit. The amount of depreciation accumulated over the years appears in the balance sheet. In the balance sheet we see first the gross block, which is the actual amount, paid for the acquisition of all the fixed assets on the company books over the years. Under this figure appears the accumulated depreciation for all the assets. After this appears the net block which is the difference between the gross block and the accumulated depreciation. In other words, net block is the residual cost of the fixed assets, which is yet to be allocated as expense. How each asset has been depreciated can be seen in the schedule on fixed assets.
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Yet, because depreciation is not a cash expense (it is an allocation, remember?), it does not affect the cash flow. Therefore in the cash flow statement we find that the amount of depreciation is added back to the profit. This treatment of depreciation leads to a wrong feeling where depreciation is thought of as a 'source' in working out the cash flow. It is not so. By adding depreciation profit is merely restored to its pre write-off level to represent correct cash inflow. Depreciation as such does not create any funds since it is just an accounting entry. Analysts studying the performance of a company are interested more in finding out if sensible depreciation has been charged, than in finding out whether correct or adequate depreciation has been charged. Sensible charging of depreciation indicates that the company has properly judged the useful life of the asset and therefore the profit reported is more 'true' to that extent. The prevailing laws of course limit this because no one can fight against the laws. Analysts are also interested in spotting any change in the method of calculating depreciation because that can directly affect the reported profit. Some amount of window dressing can be done within the framework of law but it is important to know the effect of such a dressing. We shall conclude this discussion on depreciation by commenting on a common mistake made by many students of financial statements. It is believed by many that accumulated depreciation represents funds accumulated for the purpose of buying new equipment when the existing facilities wear out. Here we would like to quote Meigs and Johnson authors of 'Accounting, the basis for business decisions'. They say,
Perhaps the best way to combat such mistaken notions (of depreciation being reserves accumulated to replace worn out equipment) is to emphasize that the credit balance in an accumulated depreciation account represents the expired cost of assets acquired in the past. ?An accumulated depreciation account has a 'credit' balance; it does not represent an asset and it can not be used in any way to pay for new equipment. To buy a new plant asset requires cash; the total amount of cash owned by a company is shown by the asset account of cash (and investment).
We hope the mystery about depreciation has been resolved.
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On depreciation
At 95% of American businesses, capital expenditures that over time roughly approximate depreciation are a necessity and are every bit as real an expense as labor or utility costs. Even a high school dropout knows that to finance a car he must have income that covers not only interest and operating expenses, but also realistically-calculated depreciation. He would be laughed out of the bank if he started talking about EBDIT -- Warren Buffet (1989 letter to shareholders)
Depreciation is an expense but it is not a cash expense. It reduces the profit for the year but not the cash inflow. This apparent anomaly gives depreciation a mysterious aura in the balance sheet and profit and loss account. The mystery however gets resolved if it is understood that depreciation is a gradual allocation of expense incurred in acquiring fixed assets spread over a number of years. The term fixed assets is used to describe long-lived assets acquired for use in the operation of the business and not intended for resale to customers. Major categories of fixed assets are tangible and intangible. Examples of tangible assets are land, building, machinery, furniture, vehicles etc. Goodwill, brand value, trademarks, patents etc are the intangible assets. The term intangible is used to describe an asset lacking in physical substance. Depreciation is mainly applicable to tangible fixed assets. Reader should note that companies generally have a policy about depreciable fixed asset. Thus a pencil sharpener worth five rupees, though technically a fixed asset, is not treated as such and is treated as revenue expenditure for its full value but a building worth a few million rupees is treated as a fixed asset to be depreciated over the years. Treatment of pencil sharpener as revenue expenditure is mainly for accounting convenience. Fixed assets, with the exception of land, are of use to a company for only a limited number of years, and the cost of each fixed asset is allocated as an expense during the years it is used. The term 'Depreciation' is used to describe this gradual conversion of the cost of a plant asset into expense. A convenient way of understanding this is to think of fixed assets as a bundle of services to be received by the owner over a number of years and payment is to be made for the service received during the year at the end of the year. The committee on Accounting Procedures of the American Institute of Certified Public Accountants has very lucidly described the concept of depreciation as follows:
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The cost of productive facility is one of the costs of the services it renders during its useful economic life. Generally accepted accounting principles require that this cost be spread over the expected useful life of the facility in such a way as to allocate it as equitably as possible to the periods during which services are obtained from the use of the facility. This procedure is known as depreciation accounting, a system of accounting which aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit in a systematic and rational manner. It is a process of allocation, not of valuation.
Depreciation is not a process of valuation. The term residual value or written down value is slightly misleading. It is really the residual amount of the original cost, which is yet to be allocated. In actual reality also the residual cost rarely, or almost never, is equal to the value of the asset in the market. This aspect can be understood by considering the example of the building. The accountant will continue to allocate the cost every year and at some point the residual cost will either become zero or very near to zero, depending upon the method of calculating depreciation, but if the company decided to sell the building the amount it would receive will be as per the market demand for that building. We should now see the two basic causes of depreciation and then proceed to the methods of calculating it. The two causes are physical deterioration and obsolescence. Physical deterioration occurs from use and exposure to atmosphere. This is simple to understand. A car used for a year is definitely not the same as it was when bought. Similarly a machine after some use is not the same as it was when new. Some wear and tear is inevitable. A time will thus come when after some years the car or the machine ceases to give any useful output. This wear and tear is the expense or the depreciation and this number of years is known as the useful life of the asset. Obsolescence means the process of becoming out of date or obsolete. Computers are a good example of equipment going out of date very fast. Technology in this area is making such rapid progress that what was efficient a couple of years ago is no longer so. Machines with Windows 95 became outdated when Windows 98 operating system arrived. Size of the RAM becomes outdated almost every year. The useful life of these machines, thus, is much shorter compared to other types of machines or buildings and therefore the amount of depreciation is also greater. In India two main methods of calculating the depreciation are prevalent. One is called 'Straight Line Method (SLM)' and the other is called 'Written Down value (WDV)' method. In SLM the initial cost is distributed equally over the useful life. Thus every year an equal amount is allocated as an expense till the cost of the asset is fully recovered. Take the example of a car. If a car is purchased for Rs. 100,000 and the useful life of the car is decided to be five years, then every year Rs. 20,000 are allocated as an expense in the profit and Loss account on account of depreciation of the car. At the end of the fifth year the cost of the car will have been fully recovered. The rate of depreciation in this case is 20% per year. In mathematical terms this will appear as, SLM Residual cost = IC{1- DY/100}, where: IC = Initial cost D = Rate of depreciation in percentage Y = Number of years. In the WDV method the rate of depreciation is the key and depreciation is calculated at that rate which is then applied to the residual cost every year. In our example of the car, for the same rate of depreciation i.e. 20%, the residual cost after the first year will be Rs. 80,000 and after the second year it will be Rs.64000 and so on. This principle ensures that the value of the car will never become zero. This is understandable because even the car fit for the scrap yard will have some value. In mathematical terms this can be expressed as,
WDV Residual cost
IC (1-D/100)^Y ;
(Symbols are same as those for SLM equation) Though mathematically a possibility exists of residual cost becoming zero if rate of depreciation is 100%, this is against the basic concept and hence overlooked. The important point to remember is that in SLM the residual cost can become zero while it can never become zero in WDV. Please note that the rate of depreciation mentioned above is imaginary. Companies have to observe rules about rate of depreciation as well as the method of calculating depreciation. In the schedule explaining accounting policies in an annual report companies disclose the method used for different assets. Since every year some expense is allocated as depreciation, it is natural that it should be deducted from the Sales revenue along with other expenses like manufacturing expenses and interest etc. Therefore we see it appearing in the profit and loss account and why it reduces the profit. The amount of depreciation accumulated over the years appears in the balance sheet. In the balance sheet we see first the gross block, which is the actual amount, paid for the acquisition of all the fixed assets on the company books over the years. Under this figure appears the accumulated depreciation for all the assets. After this appears the net block which is the difference between the gross block and the accumulated depreciation. In other words, net block is the residual cost of the fixed assets, which is yet to be allocated as expense. How each asset has been depreciated can be seen in the schedule on fixed assets.
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Yet, because depreciation is not a cash expense (it is an allocation, remember?), it does not affect the cash flow. Therefore in the cash flow statement we find that the amount of depreciation is added back to the profit. This treatment of depreciation leads to a wrong feeling where depreciation is thought of as a 'source' in working out the cash flow. It is not so. By adding depreciation profit is merely restored to its pre write-off level to represent correct cash inflow. Depreciation as such does not create any funds since it is just an accounting entry. Analysts studying the performance of a company are interested more in finding out if sensible depreciation has been charged, than in finding out whether correct or adequate depreciation has been charged. Sensible charging of depreciation indicates that the company has properly judged the useful life of the asset and therefore the profit reported is more 'true' to that extent. The prevailing laws of course limit this because no one can fight against the laws. Analysts are also interested in spotting any change in the method of calculating depreciation because that can directly affect the reported profit. Some amount of window dressing can be done within the framework of law but it is important to know the effect of such a dressing. We shall conclude this discussion on depreciation by commenting on a common mistake made by many students of financial statements. It is believed by many that accumulated depreciation represents funds accumulated for the purpose of buying new equipment when the existing facilities wear out. Here we would like to quote Meigs and Johnson authors of 'Accounting, the basis for business decisions'. They say,
Perhaps the best way to combat such mistaken notions (of depreciation being reserves accumulated to replace worn out equipment) is to emphasize that the credit balance in an accumulated depreciation account represents the expired cost of assets acquired in the past. ?An accumulated depreciation account has a 'credit' balance; it does not represent an asset and it can not be used in any way to pay for new equipment. To buy a new plant asset requires cash; the total amount of cash owned by a company is shown by the asset account of cash (and investment).
We hope the mystery about depreciation has been resolved.
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P&L in depth
This article suggests a method of rewriting the income statement for gaining clarity regarding the performance of a company. Metaphorically speaking the format suggested will show whether the company is gaining in muscle or is just adding flab. Some financial terms have found a permanent place in every day usage. 'Bottom line' is one such term. A little later the term 'Top line' also started gaining in currency. This is but natural because if there is a bottom line, general expectation is that there should be a top line too. These lines, top and bottom, appear in the income statement of the annual report. In the income statement (also called a Profit and Loss account or simply the P & L account) the bottom line refers to the net profit made for the period under consideration and the top line refers to sales income. Analysis of an income statement starts from the top line, the total sales. It is here that an analyst has to make changes and clarify some of his assumptions. This is necessary because the main objective should always remain in view, which is to gain greater clarity and also to seek easy means of comparison between two or more companies. Generally, in the case of finding investment potential, the objective would be to find the 'true' income of the company. By 'true' we mean that income which has come out of the declared main activity of the company. Though we shall not totally overlook income from other sources, our main aim is to find out how the company is performing in its avowed activity. So, we shall initially overlook the 'other income' and then make adjustments for any other income, which is not of a recurring nature. Reasons for ascertaining the true income are simple and also logical. Company's profits essentially should come from its main activity. What it earns out of its investment activity is the butter and jam on the bread and not a reward for its own toil and sweat. We are interested in finding out how the company is faring in the existing market on the basis of its product. In other words how it is earning the bread without which the butter and jam are of little value. A downward trend in the income from main activity is a clear indication of trouble in the near future. If the trend continues, chances are that other income will also start sliding leading to further trouble. One more assumption is that past performance is a fair indicator for projecting future earnings. Theoretically, from investment point of view, this may not sound right because while investing in shares we are interested in the future and no one can really predict what the future has in store. Experience, however, suggests that matured companies do not deviate too much from the past. The relationship between income and different expenditure heads shows a relatively stable pattern and a major deviation therefore in any year can easily stand out. Circumstances in the past which led to record performance in either direction become apparent and if similar circumstances are expected to arise again in the future, projections become that much simpler and realistic. With the above logic a format for rewriting the income statement is
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suggested. The example taken is of Great Eastern Shipping and the idea is developed in two steps. The first step leads to a broad analysis and finer points are seen in the second step. In the first step the other income is taken out and all expenses are deducted from the operating income. The other income is then added back. This method readily shows how much dependent the
company is on its other income.
In the second step the operating and other income is further investigated to take out non-recurring items that are in the form of one time windfall or such items that are not likely to appear in future statements. Step 1. Rewritten Income statement of GE Shipping. Figures in Rs. Million.
Income from Operations Less Expenditure Operating Profit Less Interest PBDT Less Depreciation Less Provisions Operating PBT Add Other Income PBT as on P & L Acc. Less provision for tax PAT for the year
Mar 2000 9625.9 6260.3 3365.6 608.1 2757.5 1811.7 0.0 945.8 318.7 1264.5 160.0 1104.5
Mar 99 9295.0 5988.9 3306.1 578.2 2727.9 1647.0 50.0 1030.9 513.5 1544.4 280.0 1264.4
Mar 98 9150.5 5435.2 3715.3 650.4 3064.9 1558.1 85.0 1421.8 490.4 1912.2 270.0 1642.2
Note: We advise that in case manufacturing units where sales are inclusive of excise duty, it is a good practice to deduct excise duty from operating income as well as from expenditure to get a proper feel.
In the case of GE Shipping, by separating the other income from the total income, we find that the company has marginally improved its efficiency. This is not the picture that emerges from a look at the PBT and PAT, which show a continuing slide despite a continuing rise in operating income. Thus, though the slide continues as far as bottom line is concerned, the company has managed to arrest it at the operating level. This, for an analyst, is a very important finding because it tells him that things are not as bad as they look. The above figures also show, with greater ease, that the real culprits are interest, depreciation and lower other income. A view may be taken that higher depreciation is on account of higher investment in plant and equipment that was financed by liquidating some of the investments and additional borrowings, which in turn have given rise to higher interest. It may gladden the heart of the analyst to know that the company is investing in new equipment and is willing to pay the higher depreciation though it may somewhat mar the bottom line. When the market conditions improve the company may be in a position to take full advantage of the added equipment. This view, however, will have to be confirmed by going into further details. A 3.5% increase in operating income has resulted in an increase of 1.8% in operating profit, which is much better than the previous year where an increase in operating income of 1.5% had actually resulted in a decline of 11% in the operating profits. An important trend reversal has taken place here. The next step calls for a slightly detailed study of the income schedules to find out the non-recurring type of income or income from past events. Examples of such items are settlement of old claims, refund of excess income tax, income through renegotiations, recovery of some bad debts which were earlier written off and any other such items. It is true that generally such items are small in amount compared to the main income yet an analyst has to make sure that any distortions due to oversight are straightened out. Occasionally we also find some windfall items. A company may decide to sell its holding in other affiliated company during a particular year. The profit from sale of such an investment is definitely a non-recurring type if it exceeds average of earlier years. One example that comes readily to mind is of Kirloskar Oil Engines Limited when it sold a part of its holding in Kirloskar Cummins Limited. For income from earlier years it is a good practice to deduct it from the year in which it is reported and add it to the year to which it pertains. For windfall income it is better if it is deducted from the single year but maintained in the long-term analysis. Coming back to Great Eastern Shipping we find two items of the type mentioned above in the annual report for year 1999-2000. The schedule for other income shows Rs. 7 Million as 'Doubtful advances written off in earlier year now recovered' and Rs. 42.5 Million as 'Provision for diminution in value of long term investment written back'. As per our discussions, therefore, Rs.49.5 Million should be deducted from the income of 99-2000 and added to the income of 98-99. The corrected values should therefore appear as given below
Operating PBT Add O/Income (Adjusted) Total PBT
Mar 2000 945.8 269.2 1215.0
Mar 99 1030.9 563.0 1593.9
Mar 98 1421.8 490.4 1912.2
Please note that in this case the changes are in the other income only and therefore the operating PBT is left unchanged.
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A securities analyst has to find out the company's ability to generate sales and retain maximum amount out of it. What it earns out of its own muscle power is what is of main interest and the rest is to be treated as secondary. The above format allows the analyst to study this ability. If one considers Sales as the driving pump for the financial system then it is worth our while to know how much is pure water and how much is air out of all that is pumped. Both are useful but one is more important than the other is.
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Buying a stock is like owning a company. Puzzled? Learn the basics of learning to invest in stock market. Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 5 Chapter Chapter 2: 3: Understanding Equity Equities Risks Chapter 6: All about financial ratios Chapter 7: Valuing Equities
Debt and equity: how does a company decide how much is right and how much is too much? Article 1: The right debt-equity mix | Jul 30 2002 It's always difficult to choose between debt and equity when it comes to capital. Article 2: The burning question | Aug 20 2002 How much should companies borrow? Well, money is not free. Stretch is not the buzzword. Article 3: Thoda debt, thoda equity | Jan 3 2003 Some forms of capital are hybrid between debt and equity.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Capital Structure Learning To Invest - In Equity Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 7: Valuing Equities Chapter 2: Understanding Equities Chapter 5: Capital Structure Chapter 3: Equity Risks Chapter 6: All about financial ratios
The right debt-equity mix

As we saw in the previous part, capital structuring of a company is an art. Finding the right mix of debt and equity to maximise returns to shareholders is as difficult as walking on a tight rope. There is no fixed formula that can be used across companies. A company has to find the right mix for itself. And this will depend on specific factors like capital requirement, the progress of a project, cash flows expected, its repaying capacity and so on. What is solvency? After a company has figured out its debt and equity mix, we, as investors, need to evaluate the decision. Why? Because capital structure has a strong bearing on the very solvency of the company. Now, what's that? Simply stated, solvency means whether a company can smoothly service all its debt-related obligations. There are some tools that help us evaluate the state of solvency of a company. These are simple methods to know whether the current operations of a company are capable of meeting all its requirements for debt servicing. For example, let us look at some broad financials of a company - Bellary Steels and Alloys.
Bellary Steels and Alloys : The Financials (Rs Cr) Debt Net Worth D/E (x) PBDIT Depreciation PBIT Interest Interest cover (x) Net Operating Cash Flow Investment Cash Flow Financing Cash Flow Increase in Equity Increase in Debt 1999 706 182 3.9 29 7 22 28 0.8 -50 -142 194 5 189 1998 520 123 4.2 59 10 49 30 1.6 32 -376 338 27 311 1997 206 146 1.4 77 31 46 18 2.5 4 -23 21 5 16 1996 109 66 1.6 43 5 38 16 2.4 3 -8 4 3 1
Understanding interest cover A ratio called interest cover tells us how many times the company's profits cover its interest payments. After all, the profit before interest (PBIT) must at least adequately cover the interest obligations. To get this ratio, just divide PBIT by the interest. The number that you get shows how many times PBIT can meet the company's interest burden. In our example, we see that from 1997 onwards, the company has been unable to maintain a balanced debt-equity ratio. Due to higher addition of debt in its capital structure, its financials were getting hit very hard. (The pinch is more severe during hard times when the operating profits fall). Its interest costs have shot up in the subsequent years, thus proving a drain on its cash flows. So much so that in 1999, its profit before interest and taxes do not adequately cover even the interest payments. In 1999, one does not even need to calculate the net profit (or to be precise the net loss!)! Beware of debt trap!
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And look at the cash flows! A lion's share of its capital requirements is getting funded with debt. In 1999, even the operations are funded by debt. Obviously, the company needs more and still more debt to even service its interest costs (it has little option!). This lands companies like the one mentioned above in a catch-22 situation. A time comes in their life when they need to borrow more even to pay interest on earlier debt. This vicious cycle continues, and the situation is called a debt trap. Debt service cover But interest is just one part of the story. A company has to pay installments towards the repayment of debt. A small modification in the previous formula is all that is required to see if it can service all these repayments. However, to calculate this ratio, one needs to know the repayment schedule of the company. Just add the installment due for a given period to the interest. Divide PBIT by this number. And in a jiffy, you know how adequately PBIT meets the total obligations. In our example, the company has not yet started paying off its huge debt (its cash flows are so fragile!). So, let us make some assumptions to understand the debt service cover ratio. Let us assume that the loan amount needs to be repaid over a 5-year period in equal installments and the company will not take more debt. Its average interest cost on the loan amount in the past four years is 8%. We assume this to be the interest rate.
Debt Repayment Interest Total towards debt service Debt service cover
1999 706 28
2000 565 141 45 186 0.1
2001 424 141 34 175
2002 282 141 23 164
2003 141 141 11 152
2004 0 141 0 141
The total amount that the company needs to set aside for servicing debt is the sum of interest and repayment. The debt service cover is 0.1, which shows the hopeless inadequacy of the company in meeting its debt-related obligations in the next five years. There is another interesting way of looking at debt cover. Debt service cover is a simple ratio - PBIT/(installment + interest). What if we reverse this formula? It will then look like (Installment + interest)/ PBIT. This reciprocal has something interesting to tell us. If the profits of the company remain constant, this is the number of years the company needs to repay all its financial obligations. So, we had said that Bellary Steel looks saddled with debt. The five-year schedule that we assumed is overoptimistic, to say the least. When will it be able to repay its debt? If all goes well, and if its profit remains at the current levels (without deteriorating further), the company should take 10 years (=1/0.1) to repay its debt. Thus, a debt service ratio of 0.1 implies two things: * First, it means that the company's PBIT can cover just 10% of its financial obligations. * Second, it means that provided its PBIT remains constant, it will take 10 years for the company to repay all its debts (= 1/0.1)! Solvency concerns everybody - investors in debt (lenders) as well as those in equity (shareholders). Growth, capacity expansion, acquisitions et al are the ends that a company needs capital for. However, a company should not stretch beyond its means. And, equally important are concerns about how a company sources its capital (means to the ends). Hence, the solvency calculation tools come in handy and tell us about the prudence a company has exercised in determining its capital structure.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Capital Structure Learning To Invest - In Equity Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 7: Valuing Equities Chapter 2: Understanding Equities Chapter 5: Capital Structure Chapter 3: Equity Risks Chapter 6: All about financial ratios
The burning question

As we saw in the previous part, capital structuring of a company is an art. Finding the right mix of debt and equity to maximise returns to shareholders is as difficult as walking on a tight rope. There is no fixed formula that can be used across companies. A company has to find the right mix for itself. And this will depend on specific factors like capital requirement, the progress of a project, cash flows expected, its repaying capacity and so on. What is solvency? After a company has figured out its debt and equity mix, we, as investors, need to evaluate the decision. Why? Because capital structure has a strong bearing on the very solvency of the company. Now, what's that? Simply stated, solvency means whether a company can smoothly service all its debt-related obligations. There are some tools that help us evaluate the state of solvency of a company. These are simple methods to know whether the current operations of a company are capable of meeting all its requirements for debt servicing. For example, let us look at some broad financials of a company - Bellary Steels and Alloys.
Bellary Steels and Alloys : The Financials (Rs cr) Debt Net Worth D/E (x) PBDIT Depreciation PBIT Interest Interest cover (x) Net Operating Cash Flow Investment Cash Flow Financing Cash Flow Increase in Equity Increase in Debt 1999 706 182 3.9 29 7 22 28 0.8 -50 -142 194 5 189 1998 520 123 4.2 59 10 49 30 1.6 32 -376 338 27 311 1997 206 146 1.4 77 31 46 18 2.5 4 -23 21 5 16 1996 109 66 1.6 43 5 38 16 2.4 3 -8 4 3 1
Understanding interest cover A ratio called interest cover tells us how many times the company's profits cover its interest payments. After all, the profit before interest (PBIT) must at least adequately cover the interest obligations. To get this ratio, just divide PBIT by the interest. The number that you get shows how many times PBIT can meet the company's interest burden. In our example, we see that from 1997 onwards, the company has been unable to maintain a balanced debt-equity ratio. Due to higher addition of debt in its capital structure, its financials were getting hit very hard. (The pinch is more severe during hard times when the operating profits fall). Its interest costs have shot up in the subsequent years, thus proving a drain on its cash flows. So much so that in 1999, its profit before interest and taxes do not adequately cover even the interest payments. In 1999, one does not even need to calculate the net profit (or to be precise the net loss!)! Beware of debt trap! And look at the cash flows! A lion's share of its capital requirements is getting funded with debt. In 1999,
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even the operations are funded by debt. Obviously, the company needs more and still more debt to even service its interest costs (it has little option!). This lands companies like the one mentioned above in a catch-22 situation. A time comes in their life when they need to borrow more even to pay interest on earlier debt. This vicious cycle continues, and the situation is called a debt trap. Debt service cover But interest is just one part of the story. A company has to pay installments towards the repayment of debt. A small modification in the previous formula is all that is required to see if it can service all these repayments. However, to calculate this ratio, one needs to know the repayment schedule of the company. Just add the installment due for a given period to the interest. Divide PBIT by this number. And in a jiffy, you know how adequately PBIT meets the total obligations. In our example, the company has not yet started paying off its huge debt (its cash flows are so fragile!). So, let us make some assumptions to understand the debt service cover ratio. Let us assume that the loan amount needs to be repaid over a 5-year period in equal installments and the company will not take more debt. Its average interest cost on the loan amount in the past four years is 8%. We assume this to be the interest rate.
Debt Repayment Interest Total towards debt service Debt service cover
1999 706 28
2000 565 141 45 186 0.1
2001 424 141 34 175
2002 282 141 23 164
2003 141 141 11 152
2004 0 141 0 141
The total amount that the company needs to set aside for servicing debt is the sum of interest and repayment. The debt service cover is 0.1, which shows the hopeless inadequacy of the company in meeting its debt-related obligations in the next five years. There is another interesting way of looking at debt cover. Debt service cover is a simple ratio - PBIT/(installment + interest). What if we reverse this formula? It will then look like (Installment + interest)/ PBIT. This reciprocal has something interesting to tell us. If the profits of the company remain constant, this is the number of years the company needs to repay all its financial obligations. So, we had said that Bellary Steel looks saddled with debt. The five-year schedule that we assumed is overoptimistic, to say the least. When will it be able to repay its debt? If all goes well, and if its profit remains at the current levels (without deteriorating further), the company should take 10 years (=1/0.1) to repay its debt. Thus, a debt service ratio of 0.1 implies two things: * First, it means that the company's PBIT can cover just 10% of its financial obligations. * Second, it means that provided its PBIT remains constant, it will take 10 years for the company to repay all its debts (= 1/0.1)! Solvency concerns everybody - investors in debt (lenders) as well as those in equity (shareholders). Growth, capacity expansion, acquisitions et al are the ends that a company needs capital for. However, a company should not stretch beyond its means. And, equally important are concerns about how a company sources its capital (means to the ends). Hence, the solvency calculation tools come in handy and tell us about the prudence a company has exercised in determining its capital structure.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page In the last two parts, we have learnt about the two broad forms of capital - equity and debt. We now know that these represent two ends of the capital spectrum available to a company to fund its business. And a good company balances its equity and debt capital to maximise return on equity (RoE). We have also seen that a higher debt funding could lead a company to a debt trap. We have also learnt that investors in equity capital of a business bear higher risks and, hence, need to be compensated with higher returns. Another issue that is equally important with respect to equity holders is that they are the only ones with a right to vote and determine the direction of their company. Remember, owning equity is like owning a business! Investors in debt, on the other hand, are not only assured of a stable return on their capital but they also get their principal back. Hence, they take relatively lower risks and settle for relatively lower returns compared to equity holders. But that leaves one question unanswered. Can there be a form of capital that would retain a mix of the characteristics of both equity and debt? And, if yes, why would investors or companies be interested in such a hybrid capital? A company would be interested in such a capital structure only if it can reduce its cost of capital, or can help it keep its debt-equity mix within manageable limits or improve overall cash flows. Investors, on the other hand, would be interested in such a capital structure if it can provide them better risk-adjusted returns or can help them maximise their post-tax returns. The objectives make sense - but how do these structures fare in practice? Let us look at the most popular form of hybrid capital - the preference share capital - to understand how these blended capital structures work. Preference capital defined Preference capital is a share capital that has a fixed rate of return. It is called preference capital because holders of preference shares get preference over ordinary shareholders at the time of receiving dividends. In other words, a company will pay dividend to a preference share capital holder before offering the same to an investor in its equity capital. Obviously, the preference share capital holder does not have voting rights. How does the corporate benefit? Consider the various cases listed below for Capital Company. The company has a capital of Rs100cr, split between Rs30cr of equity and Rs70cr of debt. It is earning a RoE of 32.8% with this capital structure. Let us suppose the company raises Rs20cr of preference capital at a dividend rate of 12%. (We will shortly let you know how even a dividend of 12% makes sense to an investor.) Continuing with our example, the first benefit to the company comes in the form of a drop in its debt costs as the debt to equity ratio improves. As we see in Case B, the RoE improves from 32.8% to 34.7%. Mind you, the risk of the business also comes down as the leverage drops. In other words, Case B clearly demonstrates how substituting debt with preference capital helps a company improve RoE to shareholders. Capital Structure Learning To Invest - In Equity Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 7: Valuing Equities Chapter 2: Understanding Equities Chapter 5: Capital Structure Chapter 3: Equity Risks Chapter 6: All about financial ratios
Thoda debt, thoda equity
Capital Company Case A Liabilities Equity Pref. Capital Debt Total P&L Sales Op. Profits Deprn. PBIT Interest 100.00 35.00 5.00 30.00 14.00 100.00 35.00 5.00 30.00 9.50 70 100 30 30 20 50 100 Case B
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Interest Rate PBT Tax Tax Rate PAT Pref Dividend Dividend Rate Retained Earnings RoE Lesstax Company Case C Liabilities Equity Pref. Capital Debt Total P&L Sales Op. Profits Deprn. PBIT Interest Interest Rate PBT Tax Tax Rate PAT Pref Dividend Dividend Rate Retained Earnings RoE 12.8 42.67% 100.00 35.00 5.00 30.00 14.00 20.00% 16.00 3.20 20.00% 12.80 0.00 100.00 35.00 5.00 30.00 9.50 19.00% 20.50 4.10 20.00% 16.40 2.20 12.00% 14.20 47.33% 30 0 70 100 30 20 50 100 Case D
20.00% 16.00 6.16 38.50% 9.84 0.00 9.84 32.80%
19.00% 20.50 7.89 38.50% 12.61 2.20 12.00% 10.41 34.69%
Now suppose, Lesstax Company substitutes Rs20cr of debt with preference capital just like Capital Company. The improvement in RoE in such a case is startling. Hence, it makes even more sense for companies with a lower tax rate to opt for preference share capital. Thus, a company raising funds through the preference capital route pays a lesser cost on capital, and hence earns a higher RoE without stretching its borrowing limits. This option makes even more sense for companies with a lower tax rate. How does the investor benefit? Income from corporate dividends is tax-free. Hence, an investor in debt, though he may earn a 19% return, ends up paying taxes on the interest income, which reduces his effective return to 11.7%. However, with a 12% dividend on preference capital, the investor realises higher returns on his investment without undertaking higher risks.
How does the investor benefit? Income from corporate dividends is tax-free. Hence, an investor in debt, though he may earn a 19% return, ends up paying taxes on the interest income, which reduces his effective return to 11.7%. However, with a 12% dividend on preference capital, the investor realises higher returns on his investment without undertaking higher risks. Thus, preference capital offers not only higher RoE to the equity shareholders but also achieves higher returns for the investors in preference capital.
Now we know why hybrid capital structures with a blend of equity and debt characteristics are so very popular.
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Buying a stock is like owning a company. Puzzled? Learn the basics of learning to invest in stock market. Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter Chapter 2: 3: Understanding Equity Equities Risks Chapter 6: All about financial ratios
Chapter 7
PE, PEG, PBTletters everywhere. Your survival kit for understanding analyst jargon... Article 1: Yeh P/E kya hai? | Aug 23 2001 This is the most tracked ratio in the market. And possibly the least understood... Article 2: I thought low PE was better | Jan 2 2000 PEG ratio in detail Article 3: Alphabet soup for valuation | Sep 13 2001 You are already familiar with EPS, PE and PEG. But how about EV and RC? Did you know that a stu... Article 4: Meet EV and EBIDTA | Dec 18 2001 Allow us to present two more members of the Alphabet soup: EV and EBIDTA. What do they do? Article 5: Valuing intangibles | Jul 26 2002 Intangibles are to value what love is to happiness. Don't believe us? You will soon. Article 6: Price to Net Asset Value | Feb 1 2001 Discover the peculiarity of the 'net asset value' that makes it a great valuation tool.
Chapter 7: Valuing Equities
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Article 7: The price-earnings tango | Dec 20 2001 Why do some stocks have higher PEs? Explore the relationship between prices and earnings. Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Valuing Equities Learning To Invest - In Equity Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 7: Valuing Equities Chapter 2: Understanding Equities Chapter 5: Capital Structure Chapter 3: Equity Risks Chapter 6: All about financial ratios
Yeh P/E kya hai?

Today we commence our statistical journey into the world of analysis. In this edition we are taking up the subject of Earnings Per Share, EPS in short and PE or Price-Earnings ratio. Rings a bell, does it?. Yes, this is the most tracked ratio for determining the value you are paying for a stock. Here?s a piece of conversation that Manubhai, head of a big brokerage firm, has been a part of umpteen times. The novice investor seeking his guidance this time is Ramesh. Ramesh: Manubhai, I read in your report yesterday that you are recommending HLL. And your report said you like it because it is cheap. But it is 2400 rupees per share. Better than that, why don?t you recommend Henkel Spic instead. It is only 130 rupees. Manubhai: Ramesh, price mut dekho. Price earnings ratio dekho. Speak to my analysts. They will explain?you cannot judge cheap or expensive by price. What is a price-earnings ratio? The normal reaction when we look at share prices is?a Rs40 stock is cheap, and a Rs 1,000 stock is expensive. Let?s say we were buying onions. One subziwala said Rs 20; another said Rs 100. Would we simply jump and say that Rs 20 was a great deal? What if one was saying Rs20 for half kg of onions and another was offering 10kg for Rs100? There?s a lesson here: Price itself is not enough?it actually takes a ratio to determine cheap or expensive. And the ratio is price per unit of whatever we are buying. But someone might still say that stock prices are already ?per share?. So Rs40 per share and Rs1,000 per share should be comparable. This is where we need to look beyond the piece of paper (or with demat stocks, not even the paper). What are we buying when we buy a share?
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When we buy a company?s share, we buy a share of the company?s profits, both current and future. As an example, let?s take HLL. During the period Jan 1998 to Dec 1998, HLL made a net profit of Rs805cr; it currently has a total of 20cr shares. Each share (and therefore its owner) owns Rs40.3 (Rs805cr divided by 20cr shares) of HLL?s net profit. This Rs40.3 is then referred to as earnings per share of HLL. So, when we buy one share of HLL, we are buying Rs40.3 of net profit, together with the right to future net profits. If HLL were to make a net profit of Rs1000cr this year, and were to issue another 5cr shares, the earnings per share for next year would be Rs40: Rs1000cr divided by (20cr old shares + 5cr new shares = 25cr shares) = Rs40 per share Keeping this in mind, now let?s go back to our original problem. How do we figure out if a stock is cheap or expensive? If we buy a share for Rs1000, and the earnings per share for the company is Rs100, then we are paying Rs10 for each rupee of net profit we buy into. If we buy a share of another company for Rs40, which has an earnings per share is Rs2, then we pay Rs20 for each rupee of net profit we buy into. Which one is cheaper? When we look at a share price, we should also look at earnings per share. Looking at both of them is the only way to determine whether the share is cheap or expensive. To make it easy for themselves, research analysts have created a simple formula: Price Earnings Ratio = Price per share/Earnings per Share where, Earnings per Share = Net profit /Number of issued shares So when they want to know whether a share is cheap or expensive, they just calculate this ratio. And lower the ratio, cheaper the stock is. Just to summarise: When we buy a share, we actually buy a share of the net profit of the company. How much depends on two things?how much net profit it has made, and how many shares it has. Net profit per share is called earnings per share or EPS, and is what the owner of one share is entitled to out of the total net profit made by the company. The price per share divided by the earnings per share is the Price Earnings Ratio (PER) and is a measure of how much we pay for each rupee of net profit of the company we buy into when we buy a share. But a low PE is not enough Is a stock which quotes at a lower PE always a better buy? Not necessarily. Let us just step back in time to January 1998. Punjab Tractors was trading at Rs628 which placed it at a PE of 23, whereas Telco was trading at Rs300 which placed that stock at a PE of 10. So, which stock would you prefer to buy? Just take a look at the chart down below and it is quite clear that while you would have made money by buying Punjab Tractors, you would have lost money by buying Telco. So what went wrong? The market always looks at the future, not just at the past. The PE ratios mentioned above were based on the profits (EPS) earned by the company in the year already past. But the market looks to the future. Look at the table down below and you will see that Punjab Tractors? PE is much lower when you look at its future earnings. Punjab Tractors & Telco?A Comparison
Punjab Tractors PE Telco PE
Market Price Jan 1998 1997 628 27.01 23.3 300 29.0 10.3
1998 46.47 13.5 11.0 27.3
EPS 1999 59.39 10.6 3.5 85.7
CAGR 48 -65
Market Price 1999 1061 233
Punbaj Tractors & Telco?Stock Price Movement

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In the following two years, Punjab Tractors grew earnings by 48% while Telco?s EPS dropped 65%. As a result, in 1999 Punjab Tractors? PE dropped to 10.6 (on 1998 prices) while Telco?s PE went up to 85.7. Now, which one is expensive? All those who did buy into a bargain PE must be ruing their decision. The point we are trying to convey is that the most critical factor that determines PE is future growth. Higher PEs do not always indicate an expensive stock. That?s where we use the PE?growth ratio (PEG). This ratio enables us to catch stocks with growth, at a reasonable price. The lower the PEG, more attractive the stock and vice versa. We will take up this ratio in detail the next time. We would also look at two other ratios?ROCE and RONW?that also determine PE of a stock.
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I thought low PE was better

In the last session we covered a key stock evaluation tool, EPS, and how it is to be interpreted through the price-earnings ratio (PE). We also briefly touched upon the relation of EPS growth to PE. We however stopped short of explaining how the same is calculated and interpreted in a real time scenario. Continuing from where we left off, in this issue we take up the PEG ratio in detail and also dwell on the capital efficiency ratios-ROCE & RONW. What is a stock's PEG ratio? The objective of the PEG ratio is to attempt to catch a fast-growing stock at a comparatively cheap price. First the formula for calculating PEG. The PEG is calculated by dividing the PE by the forecasted EPS growth. Thus, PEG = PE /EPS growth This ratio is explained better with a real time example. Let's look at Punjab Tractors and M&M. Over three years (1997-99), Punjab Tractors grew 48% p.a. while M&M grew 4% p.a. While we were buying Punjab Tractors in January 1998 at a higher PE, what we were essentially paying for was the 48% p.a. future growth. On the other hand, a lower PE M&M grew earnings by just 4% p.a. The lower PE was indicative of its slower growth. Market Price Jan 1998 1997 Punjab Tractors EPS PE 628 27.01 1998 46.47 23.3 1999 59.39 13.5
CAGR* to 1999 48% 10.6 PEG 0.48%
M&M
EPS PE
321
20.1
23.8 16.0
21.5 13.5
4% 14.9
4.00
The premium or the higher PE values factor in a higher growth rate, rather than indicating that the stock is overpriced. If we had picked M&M over Punjab Tractors purely because of a lower PE benchmark, we would have lost out on the earnings momentum in Punjab Tractors. What is a good PEG ratio? PEG ratio is all about catching higher growth at a reasonable price. A value below 1 is generally the thumbrule to indicate a cheap stock. A more accurate way of using the PEG would be to compare the same over companies within the sector to get a realistic result. Take the above example of the two tractor manufacturers. A lower PEG for Punjab Tractors has resulted in a higher price for the stock two years down the road. After PEG, another factor that is also relevant in determining PE is the capital efficiency of a firm. In analyst terminology, there are two ratios-ROCE and RONW. ROCE is the Return on Capital Employed and RONW is the Return on Networth (shareholders' capital). These are also termed as return ratios. What does capital efficiency really mean? Take an option-would you prefer bank interest of 12% or 10%? Pat would come the answer: "12%, why would I invest in lower returns?" Definitely, a higher return on capital is what everyone aims for. In this case, what you are doing is making that little money of yours work harder. The higher interest you earn, the higher the returns, and more the capital efficiency. It is money wisely invested. While investing in a company, have you ever used the same principles and looked at what kind of returns the company is generating on the money deployed? Haven't so far? Well, read on.
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While the EPS has its relevance in determining price, the drawback of this ratio is that it takes into account only the equity in computing the ratio. This would present a slightly distorted view, in the sense that the entire shareholders' capital, which also includes reserves, is not taken into calculation. That's where RONW presents the right picture. It takes into account the entire shareholder capital and returns are calculated on the entire base. This is why this ratio is known as the 'Mother of all Ratios'. Capital to the company comes in two forms. Debt and equity. The equity portion of the company is contributed to by the shareholders-also the owners. They have a right to the profits of the company and also the accumulated reserves. The cumulative equity and reserves is together classified as Networth, or shareholders' capital. The other part of the fund structure is made up of debt. This is the capital has a cost that is paid for. The cost is commonly known as interest. From the owner's perspective, the money which is residual with the company after meeting all its expenses is his final return. The efficiency of his capital can be gauged from the RONW ratio. This ratio spells out as to what return the company has generated on the total Networth deployed with the company during the year. RONW is calculated as: RONW = PAT/Networth Where, Networth = Equity + Reserves While RONW would only cover the returns on shareholders' capital, the ROCE would broaden the base and calculate the return on the total capital employed in the company. Thus, while calculating this ratio, we take a much broader denominator into account, which is Networth and the debt. Thus, ROCE = PBIT/Total Capital Employed Where PBIT = Profit before Interest and Tax; and, Total Capital Employed = Networth + Debt = Total Assets. To calculate this ratio, we have to add back the cost of the debt taken, i.e., the interest. The ratio calculates the returns on all the contributors of capital.We look at PBIT as this reflects the returns earned by the business before accounting for costs related to the funds deployed in the business. How relevant are these ratios in determining PE? Like we mentioned earlier, both these ratios do play an important role in determining the PE. A company with a steady return is valued higher than that with an inconsistent performance. Let us again compare M&M and Punjab Tractor on these ratios. In 1997 and 1998, Punjab Tractors traded at a premium-a higher PE. That was due to the higher RONW that the company actually generated. The premium that the stock got was largely because it was more capital efficient. Did something go wrong in 1999? The premium on PE actually went in favour of M&M. Well, nothing wrong here. RONWs are indicative of a company's capital efficiency. The external factors that did come into play were the higher growths that M&M was achieving currently and the fact that the company has a software subsidiary which has the potential of turning into a huge one-time cash flow. What is the right ratio? Here again, there is no real benchmark for the right return ratio. This would work well in an intra- industry comparison, i.e., compare companies in the same business to determine the one with the most efficient finance structure. As in the table above, higher the ratio, better is the PE multiple. By now, we have compiled the critical factors that actually determine the PE of a company. In the next session, we will take a look at other valuation methods of Book Value, Enterprise Value and Replacement Cost and learn how to interpret them.
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Alphabet soup for valuation

By now you must have already learnt something about a few ratios (EPS, PE, PEG et al) in this endeavour to understand valuation of equities. This time, we will take you through a few more tools in an analyst?s armoury. Book Value Per Share Along with Earnings Per Share (or EPS, as we now know it), the other most talked about ratio is Book Value Per Share. This is a value stock picker?s dream number. As the term signifies, Book Value Per Share is the value per share as per the book. That didn?t help, did it? By book, we actually mean the Balance Sheet. The Book Value represents the value of a share as mentioned in the Balance Sheet. It is calculated as follows: Book Value = Networth/Number of equity shares; where, Networth = Equity + Reserves Apart from just the equity, Book Value represents the reserves that the company has accumulated through the years. Book Value thus represents the networth per share. How does one use Book Value to evaluate a stock? The Book Value is always evaluated in relation to the current market price. This ratio is known as the P/B, which is Price to Book Value. Thus, P/B = Stock Price/Book Value So what is the right P/B at which to buy a stock? Unfortunately, there is no ?right? answer. As a thumbrule, however, a ratio lower than 1 is considered attractive. Put simply, it means you are buying the stock for less than its networth. However, even this thumb rule comes with a caveat. Let me explain why. As an equity investor, wouldn?t you expect your company to earn a RONW higher than, say, the 15% return that an ICICI bond provides? Our minimum expectation from any company is that it earn at least a 20% RONW. However, when a stock has a much lower RONW, then it is only fair that the P/B reflect this poor return. In other words, if a company has a RONW of only 10%, then we would find the stock attractive only at a P/B of 0.5. The reason being that at the market price you are paying to buy the stock, the effective RONW would be 20%. Hence, we recommend that the thumb rule be used only in conjunction with the RONW rather than in isolation. So, what of stocks that trade at a P/B > 1? Are they expensive? Unfortunately, there are drawbacks to this thumb rule. The market price of a share reflects not just the accumulated networth (book value) but also the future earnings of the company. A number of qualitative factors, like the management?s vision, the company?s distribution and brand strength, etc., are also reflected in the price. These intangibles as well as the future earnings potential of the company are not reflected in the balance sheet. And hence, neither does book value per share capture these intangibles. That is why many companies trade at a significant premium to their book values. That doesn?t mean that the stock is expensive. Let?s take the example of HLL. Given that its current book value is only Rs85, the stock looks frightfully expensive at its current P/B of 30x. But before you jump to any conclusion, remember that this price takes into account the intangibles - HLL?s distribution base, its brands and also the quality of its management. Remember that HLL spends a considerable sum of money (Rs669cr on advertising in CY1998 alone!) on building and maintaining its brands. None of this expenditure, which has gone into creating an intangible asset, is reflected in its balance sheet. The other reason why the market values HLL at such a high premium to book value is its superlative financial performance and capital efficiency. HLL has grown profits at an average of 45% per annum between CY1993 and CY1998. It has also consistently increased RONW, from 35% in CY1993 to 54.57% in CY1998. It is these factors that make the stock trade at a significant premium to book value. Thus, despite quoting at a value greater than book value, the stock has consistently been hitting new highs. On to Enterprise Value... Let?s now move on to the concept of Enterprise Value. Enterprise Value is the sum total of the market
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capitalisation of a company and the total debt on its books. And what is market capitalisation? Market capitalisation is simply the market price per share multiplied by the number of outstanding shares. This, in other words, is the total price that any buyer would have to pay if he wished to buy the company lock stock and barrel and pay back all the outstanding debts of the company. The EV is typically used either in conjunction with PBIDT - profit before interest, depreciation and tax - or with replacement value. Let?s say you decided to buy out all the equity of a company and repay all its debts. What would your return be? Your return would be the profits made by the company before interest, depreciation and tax - in other words, PBIDT. Obviously, if you want a return of 20% on the funds you have deployed to buy this company, then the maximum price that you would be willing to pay would be = 5x PBIDT. The analyst community calls this the EV/PBIDT ratio. This ratio is particularly useful when trying to estimate the value of the company in a possible takeover situation. ...and Replacement Cost In estimating the value of a company in a takeover situation, EV is also used in conjunction with Replacement Cost. Replacement cost is the cost at which a similar asset can be replaced (built) at current prices. Thus, if the EV of a business is equal to its replacement cost, the business it is fairly valued; if it is lower, then it is undervalued, and if it is higher it is overvalued. The lower the enterprise value as compared to the replacement cost, higher are the chances of stock appreciation. Regular readers will recall that we had used a similar argument in one of our live recommendations - Priya Cements. We had argued that the stock was the cheapest in the sector based on the replacement cost argument:
Priya Cements? Enterprise Value and Replacement Cost Equity (cr) 2.21 Asset Replacement (Rs cr/tonne) 300.00 Market capitalisation (Rs cr) 84.02 Current capacity (mn tonne) 1.2 Debt* (Rs cr) 147.00 Replacement Cost (Rs cr) 360.00 Enterprise Value (Rs cr) 231.00 Discount (%) 35.83
Obviously, larger the discount to replacement cost, the more attractive the stock would be. Well, we have now taken you through a number of important ratios in this endeavour to understand valuation of equities. While this is not a comprehensive list, it is a handy tool-kit which will help you in investment decision-making.
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Meet EV and EBIDTA

PE, BV, EV, RC - these alphabets keep popping up in discussions about stocks and stock markets. If you do not feel at home in the maze of these alphabets and acronyms, then you might want to take a look at an earlier discussion - "BV, EV aur RC: The Alphabet Soup of Valuation". This discussion is devoted to the concept of enterprise value (EV) and how it helps in valuing companies. Enterprise value does just what its name suggests that it does - it seeks to find the market value of the enterprise
J. Simple isn't it?
But remember that the operative word here is 'market'. The enterprise value at any instant of time tells us the value of the firm as the market sees it. It does not say if that is the fair value of the company nor does it concern itself with the balance sheet value of the company. It says if you were to buy over the company what would you need to pay today. You will need to buy all its equity at its market price. Also since you are buying over the company, you assume the responsibility for all its debt. And finally, the company has some cash and investments that you inherit, and your cash outflow stands reduced by that amount. Thus the Enterprise Value is market value of equity plus market value of debt minus cash and investments. The market value of equity is the current market price of a share multiplied by the number of shares outstanding. This is nothing but market capitalisation. It goes without saying that the market value of equity is what undergoes a continuous change with the change in prices. And due to this component, the enterprise value changes continuously. As for debt, normally, the value does not change. Mind you, during periods of inflation, the value of debt instruments may fluctuate wildly. For firms, however, much of the debt consists of term loans that are unlisted and hence the value does not undergo much change. It is quite fine to take it as shown in the company's books.
Thus Enterprise Value
= + -
Market Capitalisation Debt cash and investments
What if the company does not have debt, like most software companies? Then the enterprise value is equal to the market capitalisation... Take a look at Table 1 -
(Rs cr)
Equity No.of shares (cr)
Infosys 33 6.6 47692 0 446 47529
Satyam
56 28.1 9730 291 163 10021
Mkt Cap
Add Debt Less Cash plus Investment Enterprise Value
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The enterprise value for Infosys, for example, is Rs47529cr. This is higher than the balance sheet value, which is Rs2,689cr. Also, the EV is by no means the fair value. The fair value, which can be calculated using the discounted cash flow model - may be lower or higher. Now that we know the enterprise value of Infosys is Rs47529cr, what do we do with it? Enterprise value cannot be interpreted on a stand-alone basis. Just as price or market capitalisation cannot be interpreted by themselves. To make sense out of a company's stock price, we compare it against the earnings per share or the book value per share our very own P/E and P/BV. Generically speaking, we are comparing a market variable with an operating variable. A good measure while valuing companies is to evaluate the enterprise value in relation to the EBIDTA. EBIDTA? EBIDTA stands for 'Earnings Before Interest, Depreciation, Tax and Amortisation'. It is the total income that a company has generated from its operations minus its operating expenses. EBIDTA is also known as the operating profit. Instead of 'earnings', some people prefer the word 'profit' and hence EBIDTA is also referred to as PBIDTA. "What's in a name!" as Shakespeare would say. Table 2 shows the position of EBIDTA in a typical Profit and Loss Statement...
(Rs cr)
Sales Operating Expenses EBIDTA Interest (I) Depreciation (D) Tax (T) Extra Ordinary Items Profit After Tax Amortisation (A) Wondering what's amortisation?
Infosys 921 543 379 0 53 40 8 294 0
Satyam
679 426 253 41 71 6 5 140 0
Voila! We have EV and we have EBIDTA. EV tells us the market value of the company. EBIDTA tells us the operating profit of the company. Just pause and reflect what they both together tell us.... The next time around, we will enjoy their jugalbandi...
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Valuing intangibles
Remember the game of association? Where one player has to say a word and in response the other has to say another word that the first one brings to his mind instantly. Example - for "flower," your response might be "rose", or "exam" could mean "prepare" to you. So if you extend this game, "Reliance", your answer would most likely be "big." Not surprising, since Reliance Industries has plants that feature among the largest in the world. The group contributes 3% to India's GDP and 5% to the country's tax collections - after all it has annual sales of Rs55,000cr, a net profit of Rs4,800cr, and market cap of Rs65,000cr. Reliance Industries alone has a sales turnover of Rs15847cr, net profit of Rs2403cr, total assets of Rs25503cr and market capitalisation of Rs36455cr. Compare that with another company that has risen to excellence Infosys. It has an asset base that is all of Rs833cr, sales turnover of Rs921cr and a market cap of about Rs49,000cr!! Now for the glaring comparison: for every Re1 of Reliance's assets, the market is paying Rs1.43 while for every Re1 of Infosys's assets, the market is paying a whopping Rs58.80. The gap in the market cap-to-asset ratios of these two companies is stark. And that's putting it mildly. What is it that the market sees in Infosys? We'll see that soon?. The intangible factor In our basic discussion on companies, we saw that you can't make money out of nothing. A company first invests in building assets, then these assets start working to produce the company's goods (or services). The company markets these and earns revenue. There is investment required to build assets, and assets have the ability to generate cash flows. This is the simple concept of investing in a business. But looking at the above example from another angle?. Out of Re1 of assets, Infosys is generating sales of Rs1.1. Reliance is able to generate Rs0.6 of revenues from a similar amount of assets. But Infosys can't be making money out of nothing. Clearly, there is some asset that Infosys is using which the market values and which is not evident in Infosys' balance sheet. These "invisible assets" are called intangibles. Intangibles, as my first grade teacher taught me, are things you can't perceive with your five senses. In the context of a company, "intangibles" are the assets that contribute to the creation of value but are not shown in its balance sheet. Now what are the assets that feature on the balance sheet? Plants, equipment, buildings, land, investments, cash, inventories and so on. These are called tangible assets. There are some assets that are not represented in the balance sheet and are called intangibles. But like tangible assets, intangible assets require investment too and they contribute to cash flows.
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What do you value most in Infosys? It's not its sprawling offices in various locations but its 5400-odd strong skilled workforce that has helped Infosys create the brand equity it has in the Indian software service industry. It is Infosys's ability to attract, develop and retain talented employees that has earned it supernormal growth in revenue, profits - and of course stock value - in the past few years. With its skilled manpower Infosys has built a pool of knowledge, which is driving its value. Thus its investment in human resources is an important asset today that drives the company's cash flows, though this is not accounted for in its balance sheet. Does that mean if Infosys adds 1000 people and Satyam Computers add 1000 people each, then does that mean that they are adding similar value? No, it depends on the company's ability to utilise the workforce the most productively. For instance, Infosys earns revenue of Rs0.17cr per employee compared to Satyam's Rs0.13cr per employee. This in turn is a reflection of the management's ability to best utilise its assets. Brand differentiates a product from the rest and fetches a premium Much has been said and written about the power of brands. Having a facility to manufacture and market soaps is a very small part of the story for Hindustan Lever. What is difficult is getting hold of the customer's mind in a highly competitive market where loyalty is transient. Did you know that the cost of making a bar of soap is just 25% of its MRP? The rest, and the most, of the cost difference is accounted for by the selling and distribution expense and the margin. This is the extent of the mark-up that a company is able to generate on a product like soap. A brand creates a certain promise that distinguishes itself from the rest and achieves two important objectives (among others). It helps the product command a premium and it brings in a customer's clout. Not surprising that companies are trying branding exercises in everything - even in classic commodities like sugar and cement! A good brand can be a great source of cash flow and hence is an asset. And like tangible assets, even brands require investments. Look at the ad spends of the leading FMCG companies. Colgate spends 18% of its sales turnover on advertising - all towards building its brands. IPRs and patents give exclusivity and drive cash flows Intellectual property rights are exclusive rights that a company owns for the manufacturing or marketing of a particular product that is a result of its own research. This feature enables a company to earn higher profits over a long time frame. Companies that have a rich bank of IPRs or potential IPRs have been rated well in the market. For instance, Dr Reddy's Labs has evolved a drug out of its own research. So it holds the patent for the new drug, which it has licensed to Novo Nordisk to bring the drug to the next stage. In turn, Dr Reddy's Labs receives milestone payments. So you see that patents are also a source of cash flows. Also, these patents haven't come out of thin air. Dr Reddy's has invested continuously in R&D over the past several years. Hence, although patents do not find pride of place in a balance sheet, these are valuable assets for the company. Innovativeness helps a company to stay ahead What the market also values is a company's ability to start imaginative new products and services ahead of its competitors. This trait always gives it an edge. When the market leader in the business, State Bank of India has been trading at a price-to-book (link) of 1 or less, HDFC Bank has commanded a P/BV of over 8x. And it has sustained its premium over SBI for a fairly long period of time. The reasons are not far to seek. While SBI might be the leader in size, HDFC Bank has always led the many changes in the banking industry. Talk of new banking products or consolidation in the industry, HDFC Bank has been the trendsetter and the market has valued this intangible in the company. After all, this ability is what has led the bank's 50% plus growth in the past few years while its PSU counterparts have struggled. Management quality is perhaps the most important factor By far, the most important intangible asset any company could possess. Having a great idea or a good product is just part of the organisational story. Having the ability to carry it forward and making a first-rate organisation is another - one that requires vision, competence and integrity. Also, if a great organisation relies on just one person - I am sure you can think of many examples then there is always uncertainty about the company's direction once the person is no longer at the helm of affairs. Thus, sufficient depth of management is yet another important criteria that a market values. So undoubtedly, the intangibles count Outside the balance sheet, there are many assets that are at work for the company, helping it enrich its returns for the shareholders. A very crucial difference between tangibles and intangibles assets is that there is a limit to how much you can utilise or leverage a tangible asset. You can operate a plant at 100% capacity utilisation. Beyond that it is difficult to stretch it. But for an intangible asset, there is no limit. A brand can be leveraged to a very large extent. The constraint is the size of the market. So it is clear that we need to value them while valuing companies and stocks. But intangibles have a problem associated with them: they are intangibles J. And hence it is difficult to compute their value.
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Taking the example we started out with, it is relatively easy to compute the replacement cost of Reliance's assets and their cash flows. But it is so much more difficult to gauge human resources. Consider these? Is adding manpower alone is an indicator of value creation for a software company? By that logic many companies seem to be on a recruitment drive. Why don't they all come up with similar performances? Does it suffice to be a great brand? Titan was rated as the country's best brand by a leading market research agency. Why then has Titan Industries been showing disappointing performance? So while we understand that intangibles do matter, the big question is how does one value these intangibles? That's what we will devote the next part to?.
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Price to Net Asset Value

The Net Asset Value is a parameter used to measure the market value of any organisation. Oh! - not market value as in stock market capitalisation, but the current market value of all the assets (fixed assets, cash on books, etc) of the organisation, less any liabilities. So, does the NAV represent the true value of an organisation? Well, you could say that the Net Asset Value is a measure of the tangible value of an organisation. It does not take into account intangible values like brand, distribution network, etc. So, to that extent, it does not capture the true value of a company. Superior measure to Book Value and Replacement Value Then how is it different from Book Value or Replacement Value? NAV scores over other parameters like Book Value and Replacement Cost, as it uses the current market value of the asset as a surrogate for the historical cost (as in Book Value) or the cost at which a similar asset can be built at current prices (as in Replacement Cost). NAV is best used where assets are liquid The NAV can be calculated only in those businesses where assets are very liquid and can be sold easily. Like a mutual fund. A mutual fund's assets - securities like shares, bonds - are liquid and easily marketable. And their market prices can be gauged at any point in time. Mutual funds determine the NAVs of their investments regularly, as a result. Similarly, there are other industries where the marketability of assets is very high. Take shipping, for instance. Their prime assets in a shipping company are ships. And ships are traded very frequently in the international markets. In fact, trading of ships is a source of revenue for all the shipping companies. Thus the Net Asset Value of the shipping companies can be easily evaluated. Also, the prices of the assets keep changing over a period of time. Thus NAV gives an indication of the worth of the organisation at any given point in time. While prices of assets like stocks that change very frequently need to be calculated on a daily basis, for other assets, value is calculated after relatively longer periods of time. Like in the case of our other example, ships - here, the value of ships does not change significantly overnight. How to use the NAV to value companies Thus the NAV is an important benchmark to determine the value of the assets. But how do we use it? NAV is used in conjunction with the market capitalisation of a company. While market capitalisation refers to the price that the market in its combined wisdom is willing to pay for a company, the Net Asset Value refers to the value that the shareholders will get if all the assets of the organisation are sold. We assume that a company is a 'going concern' and would not, in normal circumstances, dispose off all its assets. The price of the asset/organisation will thus generally be below the net realisable value. In case of a buyout, takeover, or when a party is acquiring controlling interest in an organisation, the purchase value may exceed the Net Asset Value. This is so because in case of a buyout, the buyer pays for the intangibles as well as the expected synergies. NAV and price behaviour in mutual funds... Consider the Morgan Fund and Mastershare. Both of these funds are closed-ended funds i.e. they cannot be sold back to the mutual funds till their redemption dates. They can, however, trade on stock exchanges.
Morgan Stanley Growth Fund

Redemption Year 2008
Mastershare
Year 2003
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Latest NAV Market Price Price/NAV Discount to NAV
14.98 10.10 0.67 33%
15.75 13.35 0.84 16%
The discount to NAV reduces as the fund approaches its redemption date. Consider the case of Taurus Starshare. The fund quoted at a discount of about 30% just three months before its redemption in March 1999. As the fund approached the redemption date, the price started converging towards the Net Asset Value. And those who bought the fund in January made a cool profit (plus the gains due to the market appreciation in that time period).
Thus NAV is a very good benchmark in case of organisations that have liquid assets. Compare this with another fund, say Zurich Equity Fund, which can be redeemed at any point in time. The NAV of the fund is Rs19.95 and it can be traded on the exchange at NAV price at any point in time at the prevailing NAV. ... and in companies with liquid assets Similarly, companies may also quote at a discount to their Net Asset Values. Consider the two shipping companies, GE Shipping and Shipping Corporation of India (SCI). GE Shipping Net Asset Value Price as on 29.1.00 Price/ Net Asset Value Rs55 Rs32 0.58 Shipping Corporation of India Rs140 Rs30 0.22
In case of GE Shipping, the promoters have announced a buyback at Rs42 a share, much above the current market price and closer to the company's Net Asset Value. SCI is also looking to sell 40% of government stake in the company to a strategic partner. Such a sale would happen at a price close to the NAV. In both these cases, the investors have an opportunity to make money. But the upside seems higher in SCI, simply because it is quoting at a steeper discount in the market. Larger the discount, better the buy Of course, price/NAV is only one part of financial analysis. For a comprehensive picture, you must delve deeper into the company. However, ceteris paribus, the larger the discount to the net asset value, the more attractive a stock would be to investors....
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The price-earnings tango

Know your PEs
'Infosys trades at a PE of 100x', scream the headlines. 'Corporation Bank trades at a PE of 3', says another.
Makes you head swim doesn't it? After all, why should one stock trade at 100 times earnings and another at 3 times earnings? Or even, at a more base level, why should one stock trade at Rs7,500 and another at Rs75? Well if the question on your lips is the latter then we suggest that you first read a story from our archives where we compare mangoes and potatoes. And if the question that's nagging at your pursestrings is the former, then you may want to check on the
concept of a PE.
But what we will attempt to do today is try and understand why stocks have differential PEs, based on some simple home truths. Investing? Look for what you get at the end of it Let's start with a visit to the first financial institution that most of us interact with in our lifetime - the neighbourhood bank. What interest rate does you neighbourhood bank offer on a 1 year deposit? My bank offers 11%. Maybe your bank offers the same, maybe it does not. But that's not the point. What does it mean when a bank offers you an interest rate of 11% on a 1-year deposit? It means that if you were to deposit a sum of money, say Rs1,00,000, then the bank would pay you Rs11,000 as interest at the end of one year. Simple, right? Now let's say that you have a few lacs of rupees with you and you want to invest it somewhere. Your neighbourhood bank is offering you 11% for a 1-year FDR but you want to get something better. Meanwhile, your friend has managed to find a bank that is paying 20% as interest. He puts a lac of rupees in the bank and gets the FDR from the bank. He refuses to tell you which bank this is or how you can put your own money there, but instead he offers to sell it to you. Some friend, huh?! Now you know that the best return your money can earn is 11%. Your friend offers to sell the FD receipt to you for Rs1,05,000. Would you invest Rs1,05,000 and buy the receipt? Sure you would because you would earn Rs15,000 on your investment, which converts into a yield of 14.25% for you. Whereas if you put the money in your neighbourhood bank, you would earn just 11%. Rs Amount invested Interest received Refund on Maturity Total receipt Gain % gain Neighbourhood bank 1,05,000 11,550 1,05,000 1,16,550 11,550 11% Friend?s FDR 1,05,000 20,000 1,00,000 1,20,000 15,000 14%
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The learning is obvious: You are - and should be - willing to pay a price higher than the actual value of the FDR because of the higher yield How much would you pay for a business? Let's take this simple homespun learning and apply it in a business situation. There is this company X that has Rs1,00,000 of equity capital (10,000 shares of Rs10) and no debt. It earns a profit after tax of Rs50,000. As a businessman, you would obviously not be satisfied with a return of 11%. For the risk you are taking, you would want maybe a 25% return. But here is a business that is earning 50%, so you would obviously be willing to pay more than the Rs1,00,000 that has been invested, to buy the business. Let say that you expect this business to earn 50% this year and 50% again next year and so on and so forth. Then you would be happy to pay Rs2,00,000 to buy the business. You would earn Rs50,000 after tax which gives you the 25% return you want. And since the business is going to earn Rs50,000 next year, you should be able to find a buyer at Rs2,00,000 at the end of the year when you want your money back. What does this all mean? You have just learnt that it makes sense to buy a company at Rs2,00,000 even though the actual capital deployed in the business is only Rs1,00,000. Since the company's capital consists of 10,000 shares of Rs10 each, what this means is that you have just offered to pay Rs20 per share to buy it. You have understood the circumstances under which it makes sense to pay a P/B of 2x. (see the table below) You have also learnt that you are willing to pay four times profits to buy the company or, in other words, you have valued the company at a PE of 4. Equity capital invested in the business No. of shares PAT (@50% on capital) EPS Purchase price of business Rate of return (PAT/Purchase price) Purchase price (per share) PE P/B Rs1,00,000 10,000 Rs50,000 Rs5 Rs2,00,000 25% Rs20 4.00 2.00
What if all the profit is ploughed back into the business? So far we have presumed that the company pays out all the profits it makes. In other words, it pays out the Rs50,000 it has made by way of dividends. Now say the company decides to keep Rs50,000 and not pay out anything. Next year it would have a capital in the business of Rs1,50,000. Let us say it is able to earn 50% on the capital in the business. So the company would make Rs75,000 as profit. Now how much would you pay for the business? Tricky, very tricky. But let's try. Here is a company with Rs1,00,000 as capital. It will make Rs50,000 this year. But I won't get anything because it will keep the money. And next year it will earn Rs75,000, which it is willing to return and thereafter it will earn Rs75,000 every year. You believe that you will be able to sell the business at Rs3,00,000 two years hence - a return of 25% for the buyer. And you will receive Rs75,000 at the end of next year. So how much would you pay to buy a business which will give you a return of Rs3,75,000 two years from now. Some simple high school math will tell you that you can afford to pay Rs2,40,000 and you would still be earning a 25% return p.a. on your investment. For the company in question, Rs2,40,000 amounts to Rs24 per share. In other words, you can afford to pay a P/B of 2.4x and a PE of 4.8x. Equity capital invested in the business No. of shares PAT (in year I @ 50% on capital) EPS (in year I) Equity capital invested in the business (in year II) PAT (in year II @ 50% on capital) Sale price of business (@25% return to the buyer) Total receivable (at the end of year II) Purchase price of business today (which yields you a return of 25% p.a.) Purchase price (per share) PE (year I) P/B (year I) Rs1,00,000 10,000 Rs50,000 Rs5 Rs1,50,000 Rs75,000 Rs3,00,000 Rs3,75,000 Rs2,40,000 Rs24 4.80 2.40
Let's now extend the example to a period of 10 years. Let say that for the next 9 years the company will not pay out any dividends. It will retain all profits and it will earn 50% on capital deployed every
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year. At the end of year 10, it will pay out all the profits of year 10 and thereafter it will pay out profits every year. This is what the numbers will look like Rs Beginning 1 2 3 4 5 6 7 8 9 10 50,000 75,000 1,12,500 1,68,750 2,53,125 3,79,688 5,69,531 8,54,297 12,81,445 19,22,168 Return on capital@50% Capital 1,00,000 1,50,000 2,25,000 3,37,500 5,06,250 7,59,375 11,39,063 17,08,594 25,62,891 38,44,336 57,66,504
Now how much will you pay to buy the business today? Remember your objective is that you should earn a compounded return of 25% p.a. for the ten-year period. In year 10, the company will make Rs19,22,168 and it is willing to pay out the amount in entirety as dividend. You should be able to find a buyer for the business at that point at Rs76,88,672 (lets call this the terminal value) as the company is expected to continuously maintain profits at that level (Rs19,22,168) from that point on. And hence the prospective buyer at that point would still get a yield of 25%. In other words, how much should you offer to pay today if you expect to earn Rs96,10,840 (Rs19,22,168 + Rs76,88,672 ) ten years hence? Doing the same high school arithmetic (with the help of a spreadsheet ), you should be willing to pay Rs10,31,956 today. At this price, you are buying the company at Rs103 per share. In other words you would be willing to buy the company's shares at 10.3x book value and at a PE of 20.6x. Stock prices reflect earnings and their potential for growth What this simple exercise in math shows us is that stock prices are a reflection of earnings. And that PEs and P/Bs are influenced by the company's earnings growth. There is a reason why companies have different PEs and that difference is the future earnings (growth) and terminal value. What we have just seen is a simple DCF analysis, the use of which has enabled us to determine what PE or P/B one should pay to buy a business. This is a concept that has its application in judging the true value of a security. The example that we chose is simplistic. Just in case you missed the point we'll spell it out. There are two other corporate policy decisions that impact this arithmetic-dividend policy and debt equity structure. We'll discuss those points some time else but it's not difficult to see how these two factors could significantly impact the calculations. Next time you see screaming headlines about PEs, you can smile. You know better.
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Buying a stock is like owning a company. Puzzled? Learn the basics of learning to invest in stock market. Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 6 Chapter Chapter 2: 3: Understanding Equity Equities Risks Chapter 5: Capital Structure Chapter 7: Valuing Equities
Analysing the report card: where to look? What to do? Article 1: The story behind numbers | Jun 11 2002 Numbers can tell us about profitability, solvency and liquidity, if we care to listen... Article 2: Of margins and returns | Jun 3 2002 Here's how to understand all that go into making a company profitable. Article 3: Keep the kitchen fire burning | Jun 6 2002 No cash? Left your wallet at home? A company without ready working capital faces the same problem. Article 4: Tracking cash flows | Jun 29 2002 Amongst the strongest indicators, cash flow is the one that puts things in the right perspective. Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
Chapter 6: All about financial ratios
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page All about financial ratios Learning To Invest - In Equity Chapter 1: Basic Concepts Chapter 4: Annual Report Explained Chapter 7: Valuing Equities Chapter 2: Understanding Equities Chapter 5: Capital Structure Chapter 3: Equity Risks Chapter 6: All about financial ratios
The story behind numbers

Talking about numbers reminds us of the mathematics classes in school days, when we would invariably get lost in a maze of numbers?mensurations, formulae, graphs et al. Numbers still remain a put-off. And yet, we seem to share a love-hate relationship with them; otherwise, why do we use them so much and so often? Through the following story, we will try and demystify some of the most important numbers used in the world of business. The story would come in several episodes. You would find an interesting tale behind each number, only if you care to listen. Our objective is to help you evaluate businesses for investment purposes by making numbers easy to comprehend. After all, ?Owning equity is akin to owning a company?. And it is imperative that you understand the numbers of the company that you invest in, no? A business can actually be assessed on the basis of several parameters?profitability (whether it is making money), efficiency (if it?s making the best possible use of its resources), leverage (whether it has the right mix of debt and equity), solvency (whether it can pay off its debts), liquidity (whether it has cash to meet its day-to-day needs) and so on. All these point to the overall health of a company?and hence, to the health of its shareholders. In order to interpret the company on these parameters, we need to know what goes behind the numbers in the balance sheet and the profit & loss statement. Let us talk about a company that seeks to manufacture soaps. To begin with, it will need a plant in place. Without the plant there would be no operations, right? To know what the company has, the best place to look for is its balance sheet. Balance sheet A Balance sheet is like a snapshot that captures a mood at a particular instant. It is a financial snapshot of a company at a given point of time. Gross fixed assets: Coming to our example, to make soap, the company needs a plant. It also requires some land along with other infrastructure to set up an office. Other facilities like pipelines and waste disposal systems are also essential. These together constitute the gross fixed assets of the company. Accumulated depreciation: But nothing lasts forever, the assets wear and tear and need to be replaced at a future date. So, every year, an amount is set aside to meet these expenses. This amount is known as depreciation charges for the year. And the cumulative amount collected for the given period shows up in the balance sheet as accumulated depreciation. Net fixed assets: These are nothing but the gross fixed assets less the accumulated depreciation. All they connote is the book cost of the existing assets. Capital work in progress: When the company grows and expands its operations, there are often unfinished plants, buildings under construction and so on. These are clubbed under capital work-inprogress. Meanwhile, the plant is ready to commence operations. But can we straightaway get into the act of manufacturing soaps? Not really. Some other current requirements, those of raw materials, need to be met first. The suppliers of raw materials also need to be paid. Current assets, current liabilities: Liabilities like the creditors (suppliers of raw materials, fuel, etc. on
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credit) and provisions for tax that need to be paid immediately are called current liabilities. Similarly, there are some current assets. Unlike plants or buildings some assets like debtors and inventory of soaps that are in the company?s godown can be converted into cash more easily. What is crucial here is that the company? s current assets and liabilities balance comfortably; so that it does not face a cash crunch or has surplus of cash. The difference between the current assets and current liabilities is called net current assets. But all this can happen provided there are funds. So, the company raises funds? Equity: This is the amount contributed by the shareholders of the company at the initiation of the business. This is simply the number of shares multiplied by the face value. Reserves and surplus: As we saw in the profit and loss statement, from the total proceeds received, all the expenses have to be taken care of, tax has to be paid, and dividend has to be given to shareholders. The balance is called the retained profit. This is what the company would retain to re-invest in the business to propel further growth. This would get reflected in its balance sheet as reserves and surplus. Equity and reserves are together known as shareholders? funds?funds at the command of shareholders to be invested in the business. They are also referred to as net worth. Loans: But the entire business can rarely be funded by shareholders? funds alone. A company usually resorts to debt to bridge the gap between the requirement and the supply. These are called loan funds. Thus, we have the liabilities?funds owed to shareholders and debt holders?these constitute the company?s debts. Investments: After the operations start, money begins to flow in. Just like you put your surplus cash in stocks and other investment avenues, so does the company and the amount is shown as an asset (hopefully, the company makes sound investment decisions!). The statement that takes stock of the operations of the company during the entire given period is called the profit and loss statement. Profit and loss statement We are very familiar with the figure called net profit. So, what is the story behind this number? We have to cross several hurdles before we can actually understand what net profit means (remember, it is also called bottom line!). Let us take a fast local and halt at important stations that would help us understand net profit better. Operating profit: It is one of the prime drivers of profitability at the end of the day. If the company produces 10 soaps at a cost of Rs2, spends Rs0.50 on advertising them and pays a commission of Re1 on each soap to the retailer/dealer, then its total production cost works out to Rs35. It then sells each soap for Rs10, earning a total of Rs100, which is its net realization. But, its operating profit works out to only Rs65 (net realisation minus total production cost). Thus, operating profit is a good indicator of a company?s ability to make money from its core operations. Depreciation: For its operations, the company uses capital?like plant and machinery. Depreciation is a cost that is charged for use of plants and building. It is not cash expenditure. Any asset?be it a plant or a machinery?eventually wears off and needs to be replaced. Depreciation is an amount set aside every year towards replacement of the assets. Finance charges: The company requires funds to invest in assets and to run its day-to-day operations. After all, a plant has to be put in place and costs incurred in producing and selling the products, before the company can reach the final consumer?and more importantly, before money can be realized! These expenses are funded by a mix of shareholders? funds (called equity) and borrowings from others (debt). Sometimes, the company might also lease a plant from a different party for a periodic payment (just like you might rent a flat). While the company is not obliged to pay its shareholders (after all, it is their company and hence, its risks and rewards are also their own!), it has to pay for using others? funds. Thus, the company has finance charges like interest and lease rentals. Other income: While operating income can be viewed as salary, other income can be compared to bonus. The company invests its surplus cash in several avenues like debentures and equity of other companies. These investments yield dividends and interest income, which together constitute other income. Adjustments for extraordinary items: Sometimes, there are one-time expenses in the form of provisions (for tax, dividends, bad debts, etc.), write-offs (treating some bad loans as permanent losses), etc. Then, there may also be a one-time income from sale of certain assets. All these classify as extraordinary items. While analysing performance, one should discount these items to get a better picture of a company?s business operations. PBT: After paying for all the expenses, this is what is left in the company?s kitty. Tax: But then, do you carry your entire salary home? Neither does the company. Based on tax regulations it has to shell out Income Tax ? its contribution to the state kitty. Net profit: Well, home at last! This is one number that summarises the company?s operations. Dividends: After paying all the other stakeholders in the business, the company pays dividends to its shareholders. But, how often have you bought a stock for dividend purposes only? If fixed payment is what
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one is looking for, then there are debt instruments after all! So, how else do the shareholders benefit? They gain from capital appreciation, which is linked to the fortunes of the company. Thus, we see that a company?s net profit is dependent on several factors and prudent management of each would adds to its growth. Moral of the story:
A company invests money in assets to commence operations that are financed through debt and equity. Balance sheet gives a snapshot view of a company?s financial health at a particular point of time. The profit and loss statement summarizes a company?s operations.
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Of margins and returns

The story so far.... Last time we were introduced to the characters of the story. We also learnt how the balance sheet of a company is a snapshot view of its assets and liabilities. The profit and loss statement, we saw, takes stock of a company's operations for a given period of time... Here, we will learn how the various characters interact among themselves. We all dream of owning a stake in a profitable venture, don't we? But, what are the ways in which we can judge a company's profitability? Well, we will need to look at concepts like margins and returns. Margins It is a set of ratios that talks about the profit generated on sales and helps us to compute what is popularly called "margin" on business activities. Since, it is indicative of profitability of a company's operations, it involves only the elements of the profit and loss statement. The most important margin ratios are: Operating profit margin (OPM): This is simply operating profit divided by sales. This ratio is indicative of the operating profit generated per rupee of sales in percentage terms. If a company's operating profit margin is 30%, it means that for every sale of Re1, it earns 30 paise after paying for its operating expenses. Net profit margin:A sibling of OPM, this ratio is net profit divided by sales. It tells us how much net profit has been earned on every rupee of sales generated. We agree that the margin ratios tell us about the gains from a company's operations. But these operations are financed by the funds of the company's stakeholders. So, we, as shareholders, are interested in knowing how much returns our company generates by using our money...after all, we need to know if we have invested in the right business! Returns The "return" ratios tell us how much profits have been generated from the resources invested in a business. A return on net worth (RoNW) of 24% implies that Rs24 has been earned using every Rs100 of shareholders' funds. A company with a higher return ratio (say a 30% RoNW) is able to generate greater profits (Rs30) from every Rs100 of its shareholders' resources. Naturally, we are better off investing in the second company. By the way, if you remember, we have already spoken about the return ratios at length in our "Market Musings" section in Taking Stock dated 5-12 November, 1999. Meanwhile, as we said last time, there is not just any one formula that drives profitability. Several factors contribute to a company's overall profitability. And one such factor is the company's efficiency, which basically indicates how hard the company makes its assets work -to generate higher returns. Efficiency Most of us would remember eyeing the top rankers in our primary schools with envy and wondering how they managed the high grades. We would also remember our mothers explaining that they managed to do so because they used their time wisely. Well, the same holds true even in businesses. A company needs to use its assets smartly to beat its competitors. And prudent utilization of capacity is one way of staying ahead in the race. Let us take the following example: while ACC utilizes only 80% of its total capacity, Gujarat Ambuja Cement operates at a utilization level of over 100%. This is one of the reasons why the latter is viewed as the most efficient player in the cement industry. Another efficiency parameter that is useful is the assets turnover ratio. Consider this very familiar scenario: Pepsi Cup Finals. A 50-over, one-day match. India needs 150 runs from a limited 141 balls to win. Batsman A has scored 63 runs off 92 balls while B has managed 41 runs off
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42 balls. So, whose batting would you rate as better? I am sure that B will be your choice because he has played efficiently--it is, of course, possible that his score has been replete with 4s and 6s (sounds like Tendulkar, doesn't he?). Player A, on the other hand, has consumed a lot of balls and produced fewer runs. The same analogy can be extended to companies as well! Continuing with the previous example-Gujarat Ambuja has a capacity of 5 million metric tonnes per annum (MMTPA) (if you go to buy such a plant in the market, it would cost you about Rs1750cr). It generated a sales turnover of Rs1250cr in 1999. On the other hand, ACC has an 11.4 MMTPA capacity (would now cost about Rs3990cr!) and it generated sales of Rs2607cr in the same year. ACC makes Rs228cr per million tonne of capacity, while Gujarat Ambuja makes Rs250cr. Clearly, though ACC has larger capacity and bigger sales, Gujarat Ambuja makes cement more economically and gives better value to its shareholders. No wonder then that it commands a premium of other cement companies! But efficient use of assets is not the only key to success. Sound management of cash for one's day-to-day operations is equally essential. Students of finance like to call it "working capital management". But enough for today. We'll go into the details of working capital management, and some more concepts, in our next classroom session. Moral of the story:
To understand the profitability of a business we look at margins and returns. While margins indicate the share of revenues left after paying the expenses, returns reveal the profit generated on the funds invested in the business.
But several other parameters also impact profitability. Better and efficient utilisation of assets contributes to higher profits in the long term.
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Keep the kitchen fire burning

The story so far... We first familiarized ourselves with the various characters-balance sheet, profit & loss statement, etc-and then saw how these characters interact among themselves to indicate the level of profitability of a company. Taking the story forward, we now take up the issue of working capital management, as promised last time. Working capital management Working capital is important for us as well as companies Have you ever left home without your wallet? If you are among those who have not had the misfortune, then try it. On a normal day, you might need cash to pay for your bus/train ticket, for your lunch/dinner, buying vegetables & groceries. Not to forget, some flowers for your better half on the way back home. Life can be quite difficult without some money in your pocket. While all these expenses recur on a daily basis, you do not get paid on a daily basis. Most probably you have your salary credited to your bank account at the end of every month. In other words, you have a mismatch in cash flows. Thankfully, resolving that is not too difficult. The money in your bank will be used gradually during the month to pay the school fees, pay for the groceries and in general run the house. Some of it will get saved and might get invested in the bank or in the stock market (if you read our Taking Stock reports regularly!). So you need to manage your affairs diligently till the next pay cheque comes in. Similarly, a company has day-to-day activities that need to be paid for. Buying office supplies, paying for air tickets, freight costs and, not to forget, paying your monthly salary, among others. It also needs to maintain an inventory of raw materials and finished goods to keep its factories running and the customer's demand satisfied. Last but not least, the company might be selling on credit, in which case the cash from the sale of its product will flow in with a lag. To do all of this-meet day-to-day expenses, maintain inventories and sell on credit-the company needs cash. Now, it could get its suppliers (who supply it with raw material) and the travel agents (through whom it books air tickets) to offer a credit period as well. But that is unlikely to be enough. It will still need to arrange for funds to meet this working capital requirement. So there you have it-working capital is nothing but the capital that must be deployed to enable the business to run without being disrupted by a mismatch in cash flows. But excess working capital can pull down profitability Unfortunately, while working capital is a must to keep the company going, it is also an inefficient use of the company's resources. In the sense that the funds that are deployed in this working capital do not in anyway add to the profitability of the company, though they do aid the flow of operations. However, if a company could manage its cash flows in such a way that mismatches are minimal, it also means that it requires less capital to run the business, as working capital requirements would be low. Thus making the business more profitable. To put things in perspective, let us quickly run through the elements of working capital for a company. Among the Current Assets in the balance sheet, we saw that there is the pile of inventory lying in the godown, the debtors who are yet to make the payments, loans and advances that have been made (may be to subsidiaries), and the cash balance in the bank. Current Liabilities similarly include the creditors lining up outside the gate for their payments and the provisions that have to be made for taxes, dividends and so on. The difference between Current Assets and Current Liabilities is called Net Current Assets. But one important point to note here is that, excluding cash, the rest of the Net Current Assets (accountantspeak for working capital) needs to be funded from some other source. Time to see some examples, to help you appreciate the need for efficient working capital management.
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HLL Sales Turnover Inventories Sundry Debtors Cash and Bank Balance Loans and Advances Current Assets Current Liabilities Provisions Current Liabilities Net Current Assets Current Ratio Quick Ratio NCA / Sales %
1999 10203 1146 193 660 610 2609 1878 525 2403 206 1.1 0.6 2
1998 8333 1045 145 575 437 2202 1674 406 2079 122 1.1 0.6 1
Godrej Soaps Sales Turnover Inventories Sundry Debtors Cash and Bank Balance Loans and Advances Current Assets Current Liabilities Provisions Current Liabilities Net Current Assets Current Ratio Quick Ratio NCA / Sales %
1999 918 103 114 17 110 345 154 16 170 175 2.0 1.4 19
1998 768 113 62 30 86 291 79 23 102 189 2.9 1.7 25
HLL's Net Current Assets as a percentage of sales is a very small amount (2%), while it is nearly 20% for Godrej Soaps. Normally, the company funds this shortfall through short-term bank borrowings and ends up paying interest for them. If this shortfall is to be funded through borrowings at, say, 20%, then look what happens to the interest outgo. Godrej Soaps would need an amount to the extent of Rs35cr (3.8% of sales), while HLL would need Rs41cr (only 0.4% of sales) for funding Net Current Assets. The liquidity angle So, the closer your working capital is to zero, the better. But there is another angle to efficient working capital management-and that is liquidity. This is because if working capital is inadequate, there are several things that can go wrong. The company might not be able to maintain a sufficient level of inventory-which might not be able to meet a sudden burst of demand. Then again, the company might be unable to extend a credit period to its debtors-those dealers and retailers who directly deal with the customer. But how exactly do we measure liquidity? There are some ratios that tell us if the company has a "comfortable" liquidity position (by the way, liquidity simply means cash or cash equivalents for its daily routine). Current Assets/Current Liabilities: The ratio of Current Assets to Current Liabilities (known as Current Ratio) suggests the nature of balance between the current requirements and current availability of cash. A very low ratio implies a risky position when the company has barely enough to meet the needs (imagine you have to go to Vashi from CST and you have just enough in your pocket for the train and auto fare). Similarly, a very high ratio could imply that there is either high inventory (which might be the result of the company not selling its goods) or debtors (who have not paid on time)... Quick Ratio (Current Assets less inventory/Current Liabilities): But sometimes, there may be a pile-up of inventory, which the company is unable to sell for some reason. Then, the very purpose of it being called a Current Asset (which can be converted to cash) is defeated. So, in order to account for this, we deduct the inventory from the Current Assets. This ratio is called a Quick Ratio and indicates how much of assets can quickly be converted to cash to meet any current liabilities. But how high is "high" and how low is "low?" Valid question. That depends upon the nature of the business. Godrej Soaps' liquidity position, prima facie, looks better than HLL. But this requires additional funding. Which in turn means an interest outgo on the borrowings and which thus affects the coveted profitability! Thus, while a company needs to maintain a comfortable level of liquidity, it cannot overlook the impact on profitability due to the high level of liquidity. This simply means that the company has to do a tightrope walk and identify for itself the correct match. Moral of the story :
Prudent management of Working Capital is essential for smooth operations. But too much investment in Working Capital requires funds, thus affecting profitability. A company has to achieve a balance between not being starved of funds for daily needs and at the same time not having piles of cash sitting idle in the bank.
Now that we have looked at working capital management, we must tell you about a new character- Cash Flow. Every person who has ever done anything related to finance will swear by it.
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Tracking cash flows

In this lesson, we will deal with cash flow-a parameter that is an all-time favourite among the wizards of the finance world. We will shortly know why. Consider the following examples: Modern Mills It has recorded a total income of Rs49.82 cr. Its net profit is a neat Rs.13.6 cr. Wow!! The OPM and NPM of this textile company (no, it is not into software) will put even the likes of HLL and Infosys to shame. But dig a little deeper into its total income and you will see that the sales turnover is just Rs8.21cr while there is an increase of Rs40.26cr in its stock. This simply means that the company's goods are lying unsold! Shree Krishna Petro Yarns So what if it had a marginal drop in profits this year, it has been showing consistent profits . But why are its margins dipping? Why is the interest burden rising? A look at only their income and net profit figures can be very misleading. There is no dearth of companies who put all their creativity to accounting for their financial numbers. Hence, we need to look at a more honest number that is called cash flow. Cash flows Most transactions in life (whether it is in ours or in the company's) can be broken into two parts: A pays some cash to B, and B gives A some goods/services in return. We can prepare a neat little sheet jotting down only the cash transactions. Remember, only those entries make it to this statement that involve actual flow of cash from one party to another. We will call it the cash flow statement, for the sake of simplicity. Presented below is the cash flow statement of Sree Krishna Petro Yarns.
Financial Year PBT Adjustments for non cash items Operation profit before WC Adjustments for Working Capital Interest, taxes paid Extraordinary items Net Cash from operations Investment Cash Flows Financing Cash Flows Equity and Preference Capital Debt Dividends Debt / Net Worth CAGR of Debt over past 2 years
1999 49 24 73 -103 -13 0 -44 -17 53 2 56 -4 0.37 62%
1998 44 24 68 -77 -4 0 -13 -18 30 0 33 -3 0.24
1997 39 9 48 -58 -1 0 -11 -10 15 6 14 -5 0.23
To prepare a cash flow statement, we note down the inflows and the outflows of cash pertaining to any transaction. Let's try and make the cash flow statement of a company. We need to start by taking stock of the cash that is generated from the company's operations during a year. We get this simply by deducting its
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actual expenses from its revenue streams. But there are some expenses in its profit and loss statement that do not involve a cash outgo. For instance, depreciation is an amount that the company keeps aside to replace its assets in future. Since it doesn't involve actual outflow of funds, it does not feature in the cash flow statement. The profit after taxes adjusted for the non-cash expenses and incomes is called gross cash from operations. During a given year, the company has to invest in working capital-to carry out its day-to-day operations. It needs ready cash when its inventory lying in the godown increases or when its debtors fail to pay up on time or when its suppliers pester for fast payment. Whatever change occurs in these components during the year marks the net outflow or inflow of cash. And, since they pertain to the direct operations of the company, they are adjusted (added or subtracted as the case may be) with the gross operating cash flow. The end result is the net operating cash flow. This is where a stark lesson dawns upon us. Shree Krishna Petro Yarn has been increasing its profits for the past three years. Great company, is it? But, hang on. Just have a look at its cash flows! Its profits entail some costs. Interest cost has been rising consistently. To add to the burden, more and more cash is getting tied up in working capital. So, at the end of the day, the company's operations are a drain on its resources. A negative net cash from operations means that the company needs additional cash for its operations!! There is more to the story... During the year, the company makes investments-maybe in plants or perhaps in shares. These expenses are grouped under investment cash flow. In our example, the company has net investments of Rs17cr; which indicates a cash outflow from the company. But what on earth does it mean? The company has made negative cash from its operations; which means its operations have not stabilized to yield cash. And yet, it is still making more investments. Where does the money come from? Not all the investments need to be funded through internal operations. To bridge the gap between its operating cash flow and investment cash flow, a company needs external funds. These are called financing cash flow. Shree Krishna Petro Yarn has resorted to external capital-to fund both its operations and investments. It has to! Another look at its cash flow and we see that its debt is increasing every year. Now we know why its interest cost is rising by the year! So, there you are with three streams of cash-net cash from operations, investment cash flow and financing cash flow. Add them together and you have the net cash flow for the year. Our simple cash flow statement neatly summarizes where the rupee comes from and where it goes. From the cash flow statement we get a clear picture of whether a company's operations are generating cash, where and how it is spending the rupee and how it is financing its activities. There are some important lessons that can be drawn now. A company might show a neat little profit. But profit is an accounting concept. I might sell you a book but you might pay me after six months. While I might show it as revenue right now in my books, my cash inflow will actually happen after a lag. During this time, I will have to look for funding from some outside source to keep me going, and pay interest on it! At the end of the day, it is important to see how much of cash a company has on hand. Hence, it is always wiser to dig and look at cash flows. Sometimes, a company's operations might not be generating enough cash, money might be flowing out as loans to subsidiaries and the company itself might be borrowing to finance its activities. Then again, it might change its depreciation policy, write off some of its debts and so on; all these impact its accounting profit. Cash flows put things in the right perspective. Moral :
Cash flow statement records the details of where a rupee comes from and where it goes. Cash flows can be of three kinds-operating, financing and investment, thereby summarizing the entire gamut of a company's activities during a given year.
The beauty and power of cash flow lies in its simplicity. It records only cash transactions and hence, exposes the chinks in the reported numbers.
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Sunday January 08 11:33 pm
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Getting Started
Getting Started How to Begin Investing
Time to take a break from the classroom. Time to share some experiences and have some fun. Investing in stocks is a serious game, know your rules before you break it. Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 1 Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
Take a peek into the market's diary... Article 1: To trade or not to trade | Sep 3 2001 Solving the dilemma of a newcomer to the stock market who is tempted to trade. Article 2: Janus faced volatility | Mar 13 2001 Understanding how investors and traders come to terms with volatility. Article 3: My sojourns above 4000 | Jan 2 2000 FIIs, blasts, bull, crashes, MFs... the market's memoirs of its journey beyond 4K. Are there si... Article 4: Indian equities: Generation Next | Jan 2 2000 We took a peek into the future. Generation Next, a global market... Article 5: Indian elections: marked to market | Jan 7 2000 There has to be a strong divide between the markets and the political happenings...
Chapter 1: Market Memoirs
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Article 6: A costly game | Oct 25 2001 Numerous people are trading in shares of companies and to take part in this hugely popular game... Article 7: The dear, dear stock market | Nov 7 2000 Ever paid a 20% tip? Read on to discover how much you 'spend' on your brokers... Article 8: Voting for stocks | Dec 19 2000 Does the stock market really separate the wheat from the chaff? Article 9: Blame it on the big bad wolf? | Jan 15 2001 Small investors have themselves to blame more than the speculators Article 10: Red Riding Hood: Be patient | Jan 18 2001 If you must speculate then so be it, but you must have a plan. Otherwise... Article 11: What ticks the stock prices? | Feb 8 2001 Who or what send stock prices on their rollercoaster rides? The story so far... Article 12: Poles apart | Mar 7 2001 Understanding why trading and investing can never go together. Article 13: Discount sale! | Nov 8 2001 Why are there no takers for stocks when stock markets crash? Why do market participants buy whe... Article 14: Regarding stock prices | May 19 2001 Boom or bust, up or down. Do fundamentals really determine stock prices? Find out Article 15: I will thrive! Can you? | Jun 15 2001 "I can survive, I have and I will." Wondering what we are doing making such aggressive statemen... Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Market Memoirs Getting Started - How to Begin Investing Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
To trade or not to trade

I was having a peaceful nap when I was rudely woken up? I got up rubbing my eyes to hear many cries of "July 2, 2001" July 2? I strained my ears to listen to people who have always been under my shade expressing concerns. It looked like they saw no future and had no option to do anything about it. They sure were lamenting! I cupped my ears to hear well. They feared that no 'badla' and introduction of options and futures was meant to destroy the market, ie cut my roots! Surprisingly, they were not shedding a tear for me but were worried about the fact that they will no longer have the shade! How self-centred can one get! I opened my eyes wide enough to look at who were actually wailing. They all were fat people who had merely played under my shade and at times hurt my roots. In fact, they made use of a creeper 'badla' to climb up and dance on my slender branches that were meant to further my growth. But let me assure I have been around for a very long time. I have seen many people come under my shade, and fruits have grown every season on my branches. Oh! Before you confuse me for a giant mango tree and wonder what am I doing here in Sharekhan School, let me introduce myself. I am the "Indian stock market" I am over 200 years old and possibly the oldest one in Asia. My initial history is obscure. The English (East India Company), who came to India to trade, planted the seeds of my future. By 1840 (a good 160 years back), there were registered companies trading in the market with half a dozen recognised brokers. By 1860, there were 60 brokers! In fact, the first stock market mania in India happened then. The civil war broke out in the US and India was the only supplier of cotton to the world! By 1861, there were 250 brokers . Guess what happened next? The civil war ended in 1865 and there was a big slump in the market. The Bank of Bombay share, which traded at a princely price of Rs2,850 crashed to Rs87 in no time. I survived that mania and God knows how many more after that? After the slump, the brokers decided to regulate themselves. As a first step, they moved in together to stay as a flock on one street--that street is today known as "Dalal Street". Year 1899 is when the Bombay Stock Exchange was formed. You must have come here hoping to learn something and I have been just rambling. Without much ado, here are
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some facts and figures that I shall use to make a few points to you today. Here is a comparison of statistics in 1946, the earliest available statistic and statistics for 1995, the latest available. I know 1995 is still outdated but it helps make my point.
Capital of listed Companies (Nominal) (Rs. Crs) Capital of listed Companies (adj Inflation) (Rs. crs) Market Value of Capital listed (Nominal) (Rs. crs) Mkt Value of Capital listed (adj inflation) (Rs. crs) No. of listed companies Capital per listed Co. (Nominal) (Rs. lakhs) Capital per listed co. (adj Infl) (Rs. lakhs) Market Value per listed co. (Nominal) (Rs. lakhs) Market Value per listed co. (adj inflation) (Rs. lakhs)
1946 279 4431 970 15919 1125 25 407 86 1415
2000 59583 59583 478121 478121 8593 693 693 5564 5564
CAGR 11.32% 5.33% 13.20% 7.04% 4.15% 6.89% 1.07% 8.69% 2.78%
The number of listed companies is up eight times in 50 years. Inflation adjusted for these fifty years, the capital raised is up 13 times while the market capitalisation is up a good 30 times. Isn't it a sign that I have done very well over these years serving corporates that hope to raise capital for their businesses as well as investors who invest in these companies? Of course, in the interim period, most of the originally listed stocks have all disappeared, but the fact that investors who managed to pick the survivors every time would have made 8.69% per annum return or 2.78% inflation adjusted return. That's not much, you would say? Well, if you had invested Rs1,000 in 1946 it would have been Rs65,000 after fifty years. But Rs1,000 fifty years back is not equal to Rs1,000 today. In fact, what Rs1,000 was worth fifty years back would be worth Rs16,000 today. Even then, it would have quadrupled. Can you think of any other way you could have done this over the last fifty years when this country saw an average inflation of 6%? Apart from the last ten years, India ever since Independence followed a socialistic path that stunted my prosperity. True that there is no guarantee that any institution that has survived for over 200 years will necessarily survive the next 200. After all, even the great civilisations that we read about in our history books came to an end. Why else would they be in a history book?
But I have been changing. Derivatives are another way that will help me to serve my purpose better. It has worked in stock markets across. Mind you, it is nothing new here too. We used to have 'Joota' and 'Phatak' here. What has changed is that there is a lot more science now. Black & Scholes worked out a formula for pricing 'options' that is complex sure but in the world of technology you have calculators that just fetch the price for you. After all, I did exist before people knew 'P/E' and I existed before people discovered 'PEG' too. How long has it been since Ben Graham worked out a classic style of investing or a Phil Fisher evolved his own style of investing? These are all examples of investors evolving to make better investing decisions that help them create wealth for themselves on a consistent basis. We all need to evolve. I am changing for the better. Earlier, investors had to invest and manage the uncertainty of their investments in the same place. Spotting the dilemma of the investor, speculators came up. Initially, it was a symbiotic relationship till the balance broke. Obviously, with little at stake compared to an investor, the speculator made merry.
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The investors scurried for cover. But when the investors started disappearing, without them the speculators had to feed on each other and thus their race started dwindling. After all, the investors who were the very basis of their existence disappeared.
They offered to move to the neighbouring compound in order to allow the investors to thrive and thus was born the derivatives market. In case you are wondering who does the balancing act now, well they are called arbitrageurs. I am evolving! Are you? If you have no intentions, please don't wail either. Just pack your bags and don't waste my time. You are keen to evolve? I am very happy and you are my friend. Come let us prosper together. I rest my case.
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Janus faced volatility

Here is the essence of the wisdom that we have picked up along our journey to this stage. Stock prices are predictable with larger degree of certainty in the long term Traders attempt to profit from 'sentiment' and investors profit from the 'fundamentals' of the business Hence 'trading' and 'investing' need diametrically opposite approaches, attitudes and horizons Let us begin the next leg of our journey by answering a simple question. As an investor, which stock would you rather own?
Stock ABC Ltd. that goes up 100% in year 1, declines 40% in year 2, gains 100% in year 3 and drops 50% in year 4.
Stock XYZ Ltd. that advances 5% in year 1, rises 5% in year 2, gains 5% in year 3 and increases another 5% in year 4.
Doesn't ABC Ltd. seem the right stock to invest? After all, a simplistic calculation of average returns every year for ABC Ltd works out to 27.5% (200% minus 90% divided by 4). Where as for XYZ Ltd. the average annual returns works out to 5%. Most of us who wish to be investors make these simplistic calculations and decisions to chase big winners at times without realizing that there is a big risk we take as investors. Let us assume we invest Rs100 in ABC Ltd. After year 1, the investment goes up to Rs 200. In year 2, it will drop to Rs120 (declines 40%). Year 3 is a good year and the investment grows to Rs 240 (gains 100%). In year 4, the investment in ABC Ltd is worth Rs120 (50% in year 4). Imagine, you invested Rs 100 in XYZ Ltd. Year 1, it would be worth Rs105. Year 2- Rs110.25, year 3Rs115.75 and at the end of year 4, you would have made Rs121.5. This way you actually end up making more money than ABC Ltd. Would it change if you were a trader? Obviously, yes! Imagine buying ABC Ltd for Rs100 and selling at Rs200 in year 1. Selling short Rs200 worth of ABC in year 2 to make a cool profit of Rs80 (a decline of 40% on Rs200). Then in year 3, buy Rs 280 worth of ABC Ltd and sell it to realize Rs560. Short ABC Ltd in year 4 to make a profit of Rs280. Wow, a cool profit of Rs740. Whereas in XYZ Ltd, you as a trader would have still made a profit of Rs21.5
The learning: Volatility in stock prices presents an opportunity to a trader whereas it is a threat to an investor. Another fact that demonstrates that trading and investing are poles apart.
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A short break in our journey to spare a moment understanding how the investor grapples with the threat of volatility. Of course, stretching the horizon of investment helps an investor turn a blind eye to market storms. There are three active ways of handling volatility. Asset allocation or in other words the way you distribute your wealth between stocks, real estate, gold,fixed income securities (like bonds, deposits) and cash. Portfolio diversification helps handle risk too. Steady investing or spreading investments over a longer time frame is another way of smooth sailing in turbulent market waters. Time now to prepare a ground to move on? You are new to the market. You are standing at a junction. You now have these options. At the primary level, you can either be a trader or an investor. At the secondary level, you can pick between a stock like ABC Ltd or XYZ Ltd. Earlier, we have worked out that, as a trader you could have a maximum profit of Rs740 if you were trading ABC Ltd. If you were trading XYZ Ltd., you would have earned Rs21.50. Alternatively, as an investor you would have raked in profits of Rs20 in ABC Ltd and Rs21.5 in XYZ Ltd. We have represented the profits as a matrix below.
ABC Ltd. Investor Trader 20 740
XYZ Ltd. 21.5 21.5
Clearly, the maximum profit of Rs740 trading in a volatile stock like ABC Ltd stands out as the best option. Most new comers to the market make these mental calculations and jump at the option of being a trader in ABC Ltd. Is it the right choice? As Alice would ask `Would you tell me which road leads out of the wood?' The cardinal mistake most newcomers to the market make is that they assume they are taking the risks of an investor in XYZ Ltd. when they trade in ABC Ltd. in search of the maximum returns. However, we are all a lot more knowledgeable now. We know how the Janus faced volatility means two different things to the investor and the trader. We also learnt at the beginning of the journey that unpredictable sentiment rules stock prices in the short run whereas predictable business earnings dictates prices in the long run. Many of you would have already resolved the dilemma. Next time we shall address this in greater detail.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Manmohan Singh opened the gate, Big Bull did the rest The first large-scale bull market witnessed on the Indian bourses was single-handedly masterminded by the Big Bull. Manmohan Singh set the agenda for opening up the economy after India barely managed to hold out on a balance of payment crisis. The new open economy provided great potential for businesses and the stock markets rejoiced. The big bull ended up being a messiah of the stock market. He took the market to dizzy heights, levels at which the valuations were discounting the next three years? earnings! In the run-up to its high of 4467, the Sensex appreciated 109.5% in just three months. The bubble had to burst and it did, with the break-out of the scam. Nobody had bothered to query the Big Bull?s source of money! Until an intrepid journalist discovered that he was siphoning money from the banking system! The rest is history. April 22, 1992: Sensex gains 109.5% Market Memoirs Getting Started - How to Begin Investing Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
My sojourns above 4000

22nd April 1992:I hit a new high of 4467 in the shortest time
Top 5 ICICI Tata Chem Castrol Reliance BSES
% gain 271.40 238.80 190.80 190.00 175.20M
Bottom 5 Tata Power Novartis Glaxo Colgate Guj Ambuja
% gain 29.20 46.70 51.00 58.80 61.50
(Gains/losses for quarter leading to the date) 12th September 1994: After more than two years I broke my record to touch 4643 FIIs rush in where angels fear to tread The country?s stock markets saw a new breed of animal grazing in its fields ?the Foreign Institutional Investor (FII, 3 letters that struck awe!) The FIIs rushed in herd-like fashion, confident of taking on the Indian Investor still reeling under the aftermath of the great scam. How mistaken they were. Smelling them coming from a mile away, the great Indian Investors sheared the whole field and sold it to them at a premium! The rise and fall of mutual funds in India The period witnessed mutual funds coming of age in India with private players entering the field and the biggest FII ?Morgan Stanley setting up its close-ended fund. The units of this scheme were so sought after that people were willing to pay Rs17 for a unit of face value Rs10 at market levels of 4000! Subsequently, the mutual fund industry saw a setback and has managed to regain currency only in the last one year. Vultures prospered? The huge inflows of funds from FIIs inspired a lot of companies to raise fresh equity capital. While the better ones raised capital at exorbitant premia through the GDR route, others did it in the domestic market. Meanwhile, many more created companies to make money for themselves! The investment bankers and merchant bankers (two species of vultures distinguished from the other by the presence of neck-tie) thrived as they tirelessly pulled IPOs out of their hats, (not a mandatory garment) exploiting the free price regime for public issues! In the end, there was so much fresh paper available that supply far exceeded demand and the fairy tale ended.
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12th Sept 1994: Sensex gains 11.7%
Top 5 Novartis M&M Hindalco Gujarat Ambuja BHEL
% gain 48.30 36.50 33.70 28.50 30.30
Bottom 5 SBI Infosys HPCL Tata Power HLL
% gain 11.80 26.20 06.60 05.40 04.10
(Gains/losses for quarter leading to the date) 6th August 1997: I could only manage 4605 Chidambaram?s dream budget brings in more cheer The economy had been under a credit squeeze as the incumbent Government in ?94 raised interest rates to tackle inflation. Then came Deve Gowda and Chidambaram who unveiled the dream budget on 28th February 1997 that ushered in fiscal reforms, relaxation of direct tax rates, et al. This budget unleashed the animal spirits of the economy and the market responded with a spirited rally. FIIs, FIs, Locals and everybody alike united The rally this time around gained the support of all and sundry. Everybody believed in the dreams portrayed by Chidambaram. The corporates? bottom lines also swelled because of a significant drop in tax rates. This overwhelming bullishness led to a secular uptrend all the way past 4000. However, as the market approached its all-time high, many of the smarter ones woke from the reverie and realised that the dream still remained a dream. Reality caught up with the market and it was just a matter of time before collective bullishness reversed? 6th August 1997: Sensex gains 19.6%
Top 5 Castrol Infosys ICICI Glaxo HLL
% gain 81.30 61.10 61.70 47.00 44.50
Bottom 5 Indian Hotels BSES TELCO Bajaj Auto Tata Power
% gain 08.60 01.80 5.11 05.20 03.10
(Gains/losses for quarter leading to the date) 13th July 1999: I did it! I hit 4678! Asian crisis, Pokhran blasts, political uncertainty?Give me a break The intervening period between 1997 and now has been the most tumultuous period in the history of this country. A bloating Government fiscal deficit made it impossible for additional Government spending to boost the economy. Private investment was not very forthcoming in infrastructure due to lack of clarity on the policy front. The Asian tigers in the meantime got reduced to domestic cats. A combination of all these factors stifled domestic economic growth and choked Indian corporates. To add to these woes, demand failed to catch up with excess capacities created during the early nineties. UTI was on the brink of collapse, raising the spectre of a complete financial system failure. The new BJP government proved completely inept at handling this crisis. As a result, the stock markets crashed to all time low in December ?98, with erstwhile blue chips trading below book value and a majority trading below their face value. How low can low get The dismal state of the economy had forced fresh capital allocations to enter Software, Pharma and FMCG stocks as they stood insulated from the vagaries of the economy. In December ?98, a lot of frustrated investors dumped economy-linked stocks to switch to these fancied sectors. This shift not only gave the market a much-needed fillip, but also created a gross imbalance between valuations for the Software, Pharma, FMCG sectors and the economy-sensitive sectors. The cyclicals and commodity stocks started trading at ridiculously low valuations. Enter FIIs, flush with funds The BJP Government unveiled a better budget. In the meantime, the Indian corporate houses that were reeling under the duress of recession reworked and restructured their businesses by getting out of unviable businesses. Cost-cutting exercises assumed tremendous importance as the companies battled to survive. The Asian economies had recovered too, boosting commodity prices. The cheap prices attracted FIIs who were flush with funds. Market sentiment deteriorated after the fall of BJP government and it gave the FIIs a great opportunity to buy. Ever since, the market has never looked back, although the local sentiment is still
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bearish! Hence, the locals have largely been bystanders, as the market whizzed past them to touch an all time high at 4678. For once, the FIIs had the upper hand. 13th July 1999: Sensex gains 26.3%
Top 5 Grasim ICICI TISCO TELCO Hindalco
% gain 178.00 121.60 90.60 97.90 100.10
Bottom 5 Glaxo Bajaj Auto Castrol Nestle BSES
% gain 07.50 07.80 03.10 03.10 08.80
(Gains/losses for quarter leading to the date) Looking back The market has come a long way Compared to the market in 1992, today?s market is far more transparent, much more liquid, and more efficient. Unlike in the past, dematerialisation of shares has banished the nightmares of bad deliveries, forged transfer deeds and duplicate shares. In short, buying and selling of shares has become more reliable and hassle free. Corporates have realised the importance of creating shareholder value and the long-term benefits it holds for them. A majority of them have mended their ways to adopt stringent accounting policies and become more transparent to share holders. Investors have learned to separate the wheat from the chaff. Today?s investor does not hesitate to punish errant corporates. Investors have become more savvy in valuing firms for their capital efficiency, growth prospects. They have learned to use various fora like the AGMs and the Press to voice their concerns. Intermediaries of the stock market have become more service oriented. Brokers, unlike in the past, go out of their way to woo clients and retain them with better service in terms of research reports, stock ideas and efficient back-office handling. Mutual Funds have polished their investing skills to consistently perform better, in order to ensure better collections. Investment bankers have helped corporates restructure to unleash shareholder value. The Government and its associated functionaries? @#@# dinosaurs. How do we get them to change?
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Indian equities: Generation Next

July 20th 1999, 6:00 am: A dealer in a leading Indian brokerage house wakes up and, even before reaching out to switch off his alarm, rushes to look at the closing quote of ?Infy? on NASDAQ. One look at the screen and he dashes to call up his client. ?Infy? crashed $25 yesterday??barely does he finish completing his sentence than pat comes the response: ?Oh Shit! Dump 10,000 Infosys on BSE?. A new era has begun Welcome to the new era in Indian stock markets, when stocks listed on a local stock exchange trade on another bourse on foreign soil. The trend, which had started with GDRs being issued by Indian companies, has culminated in ADRs getting listed on NASDAQ?which has a very high retail investor following. Technically, an FII can trade these stocks round the clock! Factoring in new information into the stock price by the hour. Of course, it puts the domestic guys at a disadvantage, but not for long. New vistas opened with a mere listing across the globe How does a mere listing across the globe impact the existing scenario? 1. For starters, the company gets compared with a global basket of companies in its sector. In short, gone are the days when one could compare Infosys with just NIIT or Satyam; it will now get benchmarked with the likes of IBM, Microsoft! 2. A global listing helps the company to raise capital efficiently and effortlessly. 3. In an era where it is becoming imperative for companies to locate their operations across the globe so as to reach customers globally at the lowest cost and with the best quality, a $ listing offers an excellent currency for acquisitions. 4. Managements will be forced to shape up and accept global best practices. 5. Indian companies will get an opportunity to establish a global presence, attract the best talent and retain them by offering ESOPs in countries of their choice. Flip side 1. Traders can never sleep! Stocks will effectively be traded round the clock. 2. Volatility levels will increase as news gets factored in round the clock. 3. Indian markets will be indirectly exposed to the vagaries of global markets A peek into the future July 20th 2009: A dealer in a local brokerage house answers a phone to listen to a client ask him in Gujarati to look at scrip code BS g012 and buy 1000 shares at market. The dealer punches in the code and Microsoft?s (the original one!) name flashes on the screen? At the same time, in a tea garden in Assam, a man is staring at the screen of his internet broker (you know who), keying in a query: ?Should I buy Infosys or Microsoft?? 'Infosys', says the broker promptly. The man executes the order? Half way across the globe, on a sunny day in Chicago, a floor trader in CBOT futures exchange is bidding for September 2009 futures contract of BSE at (hold your breath) 20,000!
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Indian elections: marked to market

This decade has been path breaking for India in many ways. Our country partially opened the doors of its economy to start with, and the winds of globalisation swept in to open the doors further. Our software talent gained tremendous recognition. Socially too, the country came out of its closet. The music channels MTV and Channel V have changed the attitudes of the youth. The older folks have kept pace too in their own way. On the other hand, the political situation has been fairly volatile. We are having our fourth general elections in less than 10 years! (And we were taught in our civics classes that the country goes to polls once every five years). New parties have emerged on the political scene while the existing ones have split beyond recognition! (Hopefully the limited imagination of political parties in finding political symbols will put an upper limit on the number of parties!) The country has seen four different prime ministers from three different parties! We decided to revisit the elections in this decade, tracking the market movements during the period to catch any trends that will give us a better insight into the days ahead of us. Elections and the Market May 1991 V.P. Singh?s government, that came to power in 1989, wrecked havoc on the country. The Gulf war added to our woes. Chandrashekar, who stepped in after toppling V. P. Singh, was no better. The ensuing seat wrangling led to the Government being toppled and the country going to polls. Rajiv Gandhi was assassinated while campaigning on 21st May 1999. As a result, the Congress got swept to power with a marginal majority. The country had the combination of an astute politician at the mantle with an economic scholar running the affairs of the country. The country had pledged its gold to tide over a balance of payment crisis. The IMF and the World Bank insisted on the country embarking on a ?stabilisation? and ?structural reforms? programme. Manmohan Singh had no choice but to open up the economy, inviting foreign capital to meet the growing capital and forex requirements of the country. Initially, the market was unruffled by the political drama, with the Sensex trading around 1280. As the elections approached, the market staged a minor rally to 1360 levels - what everybody now refers to as the ?pre-election rally?. The market had reasons to be optimistic, as opinion polls indicated that Congress had good prospects of returning to power and anybody could have provided better governance than the incumbent government. Of course, what followed after the swearing in of Narasimha Rao?s government and Manmohan Singh?s first budget is folklore. May 1996 Though Narasimha Rao?s government managed to complete five years, the last two years were bad. The economic policies of the government were viewed as elitist and pro-rich. There was dissent within the Congress Party. As a result, the government tried to unleash reforms with a ?human face? (euphemism for inflation taming). The tightening of credit led to the industrial downtrend while the masses still felt alienated from the reform process. A number of regional parties emerged, capitalising on the electorate?s disenchantment. May 7th 1996: The election process went through smoothly and, for the first time, an election commissioner became a hero! However, the outcome was a fragmented mandate. BJP with 162 seats emerged as the largest party, while Congress got routed. A number of regional parties emerged. Janata Dal and the Left parties decided to form the ?National Front?, a third alternative. The BJP formed the government under Vajpayee but lost the vote of confidence. The Government lasted for a mere 13 days and the National Front assumed power with the passive backing of Congress. The politician-statesman combination continued with Deve Gowda and Chidambaram. The market?s ?pre-election rally? was more pronounced this time around, as it rallied from 3485 to 3796. The elections were viewed as a big relief by the market. Renewed expectations were built up of a new government easing credit and increasing expenditure to boost the economy. However, the fragmented
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mandate dampened the spirits of the market but it never let it show, remaining steady at 3800 levels. When Chidambaram became the finance minister, the market turned ecstatic as he had played an equally important role in implementing reforms as the commerce minister in Narasimha Rao?s government. The market opened the cork and got past 4000! Bonanza time?a pre-election rally & a post-election rally. Wah! Wah! February 1998 Post-1996, politicians started grappling with the realities of coalition government. The multi-party government that had been formed consisted of a number of regional parties who felt that their aspirations were being sacrificed at the national altar. The Congress played truant too. In the end, the country was forced to go to polls again. The electorate was frustrated with the performance of its elected representatives. BJP emerged stronger from all the political squabbles. BJP outdid its performance in the previous elections and got 181 seats, while the Congress did better too. However, the Janata Dal and its allies badly lost. The country voted for a national party. The elections were also a pointer to the fact that the political parties had to learn to balance between their own regional aspirations and national priorities. Electoral forces were ensuring that the political community split as BJP & non-BJP. After 50 years of Independence, the Congress had finally been sidelined... The market was completely disgusted with the happenings on the political front. The market had a subdued performance, trading around 3450 levels (back to 1996 levels). The market was tired of hoping. However, the poll results had the market completely excited as BJP came to power raising hopes of a stable government and hence, stable progressive economic policies. The market partied, crossing 4000 within a month of the Government being sworn in. Little did the market know of Pokhran and the ?Jaya? bomb awaiting it! The post-elections rally more than made up for the pre-election rally that did not happen. September 1999? The selfish interests of most politicians are still in conflict. Hence, there are too many parties fighting the polls. The Congress has split too with frontline leader Sharad Pawar going on his own. The National Democratic Alliance formed by BJP and its allies seem to be in a stronger position. However, a vote swing against the ruling government might upset the results. Congress is running an aggressive campaign, hitting hard at BJP rather than issues, in order to capitalise on this anti-incumbency factor. Are we headed for a hung parliament again?! The market has been busy chanting the economic recovery and corporate recovery themes, turning a blind eye to the elections. However, the looming elections are giving many investors the jitters. If this week?s market declines were to continue, then for the first time we might have a pre-election sell off! However, the saving grace is that both BJP and the Congress speak the same language when it comes to reforms. In fact, BJP seems to have taken a more aggressive stance on the reform process. The adverse market conditions forced the Indian corporates to restructure and shape up in order to survive, leave alone do well. Will the Indian electorate teach the political parties a lesson by punishing contestants who have not worked either for their constituencies or in the interests of the nation? That is without doubt - the electorate has cast its vote well in the past, throwing out one incumbent government after another, only to find the next government equally ineffectual if not incompetent. That is about as strong a message as the one that the stock market has made over the past 4-5 years - rewarding companies with good practices and trashing the bad ones. The issue is: when will the elected leaders do their duty to the nation by governing responsibly? The answer to this unfortunately lies in the realm of the unknown. As of now, the economy has displayed some stirrings of life and the environment is conducive enough for it to perhaps trundle along at a faster pace, going forward. We are clearly on a cyclical uptrend at this point of time. But can we enjoy the kind of bull run that we have seen in the US over the past 7-8 years? Without an enlightened government, that will remain a fantasy. The current revival in the markets will reflect just another cyclical upturn in the economy that can last for two years; and the market will retreat as and when the economic cycle reverses. Hopefully, somebody will knock wisdom into the heads of our politicians before it gets too late.
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A costly game
There is a very costly game that a large number of people are indulging in these days. The game involves trading in shares of companies. This popular sport has logged in an aggregate turnover (Bombay Stock Exchange + National Stock Exchange) of Rs10,70,000cr during the period April-September. The ten most popular stocks that game participants are trading in include worthies such as Himachal Futuristic, Satyam Computer and Zee Telefilms. Together these three hog as much as 75% of the stock market's version of television rating points (TRPs). HFCL steals the thunder However, the stock that steals the thunder with 15 TRPs is the 'born again' telecom-cum-softwarecum-entertainment company, HFCL. This all-rolled-in-one ICE heavyweight has recorded a trading volume of Rs148,209cr during the April-September period this year. Game participants love it At today's closing price the market capitalisation of the company is Rs12,000cr. This makes HFCL among the 10 most valuable companies in the country. Maybe a place in the Sensex beckons! Game participants (investors, traders and what have you!) eager to own a share of this ICE heavyweight have turned the company over a dozen times in the past six months (that is Rs148,209cr worth of HFCL shares have changed hands during the period as against a market capitalisation of Rs12,000cr) But they don't want a long term relationship HFCL is expected to report a profit in the region of over Rs250cr this year, a growth of over 150% year on year. In the ICE age it is only understandable that every market participant worth his salt wants to own a two-bit share of this company. However, data indicate nobody really wants to own this company for too long. HFCL has been bought and sold lock, stock and barrel a dozen times over. Wonder why nobody wants to hold on to this ICE maiden for very long! So, how much does a player pay to take part in this hugely popular game where the prize appears to be not a long lasting relationship with great stocks but a one-night stand? Well, any game involves some costs In this case, it is the brokerage that the game participants incur while buying and selling shares of a company. Let's assume that the participants in this game pay a brokerage of 0.1% every time they trade (and that is a pretty realistic estimate of brokerage rates prevailing in the country!). That throws up a figure of Rs148cr! It takes two to tango Now remember that in this game there has to be a seller and a buyer. It takes two to tango after all. Hence, the total fees paid by buyers and sellers in this game amounts to Rs296cr. And this is the cost of the game for six months. If this blockbuster continues to play all over gaming rooms in the country for another six months the game participants would have shelled out a rich sum of Rs600cr! All of this in an effort to take control of a company that will generate a net profit of just Rs250cr this year! Do they know something we don't or have they forgotten to do the arithmetic?
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The dear, dear stock market

Remember that costly game? The one in which you (and zillions of other market participants) offer to pay your broker, by way of transaction costs (brokerage), twice the amount of profit that a company (HFCL) will report. Well, one of our readers took offence to that story and wanted to highlight that it was not only HFCL that was prone to this kind of misplaced arithmetic by 'investors'. Gentle reader, we agree with you. We used HFCL as the flag bearer for our story only because it topped the charts in terms of trading volumes. This flawed arithmetic is not a malaise that affects HFCL alone. It affects the market as a whole. Step back in time and take a look at the words with which we started our story. "There is a very costly game that a large number of people are indulging in these days. The game involves trading in shares of companies. This popular sport has logged in an aggregate turnover (Bombay Stock Exchange + National Stock Exchange) of Rs10,70,000cr during the period April-September 2000."
It is not about the Rs600cr that investors will shell out of their pockets while trying to shuffle the cards (HFCL shares) even while the company itself will report profits of only Rs250cr. It is about the Rs2,140cr that investors have shelled out of their pockets during the 6-month period ended September 2000. Mind you, this is a conservative estimate, calculated on the basis of a 0.01% brokerage charge on turnover; that amounts to Rs1,070cr and since brokerage will be payable both by the seller and the buyer, the total bill tots up to Rs2,140cr. Extrapolating this number, investors would shell out a sum total of Rs4,400cr during this financial year. Investors dole out about 16-18% of their companies' profits in trading The combined market cap of all stocks listed at the BSE is estimated at Rs6,20,000cr (Oct 23, 200). Let's use that number as the benchmark for capitalisation for all stocks in the country, as the number of companies not listed at the BSE is quite low. The Sensex, which accounts for nearly 45% of the total market capitalisation, trades at a P/E of 18.5x FY2000 earnings. Let us treat this number as being an accurate representation of the P/E for the whole market. That means that the companies that make up the total market would have a combined profit of between Rs33,000cr. So investors as a body are doling out almost 13.5% of the profits that their companies will earn this year. And this number will climb higher when you account for the fact that we have not included transaction costs incurred by people trading at the Calcutta Stock Exchange, Delhi Stock Exchange and even the Nasdaq, NYSE, Luxembourg and London stock exchanges (where Indian GDRs and ADRs trade). Take all of that into account and transaction costs would rise as high as maybe 16-18% of all the profits generated by these companies. So there you have it - investors as a whole are doling out as much as 16-18% of all profits generated by their companies as they go about tossing shares at stock exchanges all over the world. Do you think that is a good idea or even wise? You tell us. Mind you, this is not just an Indian phenomenon. This is a global phenomenon. Listen to what renowned investor Warren Buffet has to say on this subject in an extract from a Fortune article published in 1999.
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"Bear in mind - this is a critical fact often ignored - that investors as a whole cannot get anything out of their businesses except what the businesses earn. Sure, you and I can sell each other stocks at higher and higher prices. Let's say the FORTUNE-500 was just one business and that the people in this room each owned a piece of it. In that case, we could sit here and sell each other pieces at everascending prices. You personally might outsmart the next fellow by buying low and selling high. But no money would leave the game when that happened: You'd simply take out what he put in. Meanwhile, the experience of the group wouldn't have been affected a whit, because its fate would still be tied to profits. The absolute most that the owners of a business, in aggregate, can get out of it in the end - between now and Judgment Day - is what that business earns over time. "And there's still another major qualification to be considered. If you and I were trading pieces of our business in this room, we could escape transactional costs because there would be no brokers around to take a bite out of every trade we made. But in the real world, investors have a habit of wanting to change chairs, or of at least getting advice as to whether they should, and that costs money - big money. The expenses they bear - I call them frictional costs - are for a wide range of items. There's the market maker's spread, and commissions, and sales loads, and 12b-1 fees, and management fees, and custodial fees, and wrap fees, and even subscriptions to financial publications. And don't brush these expenses off as irrelevancies. If you were evaluating a piece of investment real estate, would you not deduct management costs in figuring your return? Yes, of course - and in exactly the same way, stock market investors who are figuring their returns must face up to the frictional costs they bear. "And what do they come to? My estimate is that investors in American stocks pay out well over $100 billion a year - say, $130 billion - to move around on those chairs or to buy advice as to whether they should! Perhaps $100 billion of that relates to the FORTUNE-500. In other words, investors are dissipating almost a third of everything that the FORTUNE-500 is earning for them - that $334 billion in 1998 - by handing it over to various types of chair-changing and chair-advisory `helpers'. And when that handoff is completed, the investors who own the 500 are reaping less than a $250 billion return on their $10 trillion investment. In my view, that's slim pickings. "Perhaps by now you're mentally quarreling with my estimate that $100 billion flows to those `helpers'. How do they charge thee? Let me count the ways. Start with transaction costs, including commissions, the market maker's take, and the spread on underwritten offerings: With double counting stripped out, there will this year be at least 350 billion shares of stock traded in the U.S., and I would estimate that the transaction cost per share for each side - that is, for both the buyer and the seller - will average 6 cents. That adds up to $42 billion. "Move on to the additional costs: hefty charges for little guys who have wrap accounts; management fees for big guys; and, looming very large, a raft of expenses for the holders of domestic equity mutual funds. These funds now have assets of about $3.5 trillion, and you have to conclude that the annual cost of these to their investors - counting management fees, sales loads, 12b-1 fees, general operating costs - runs to at least 1%, or $35 billion. "And none of the damage I've so far described counts the commissions and spreads on options and futures, or the costs borne by holders of variable annuities, or the myriad other charges that the `helpers' manage to think up. In short, $100 billion of frictional costs for the owners of the FORTUNE500 - which is 1% of the 500's market value - looks to me not only highly defensible as an estimate, but quite possibly on the low side. "It also looks like a horrendous cost. I heard once about a cartoon in which a news commentator says, `There was no trading on the New York Stock Exchange today. Everyone was happy with what they owned.' Well, if that were really the case, investors would every year keep around $130 billion in their pockets." Words to chew on, no doubt! By the way, in our estimate, we did not include the fees charged by mutual funds to their investors, which is another transaction cost! If you take that into account, the number is likely to climb even further - in excess of 20% all profits! A costly game indeed!
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Voting for stocks

All voting is a sort of gaming, like checkers or backgammon, with a slight moral tinge to it, a playing with right and wrong. - Henry David Thoreau Voters Take Their Turn After Marathon Campaign - 7/11/2000 Reuters report on US 2000 elections We have all cast votes in some election or the other. It could be an election to elect our class representative in school or an election to elect the MP of our constituency. Many of our votes made candidates win. Nevertheless, have you ever wished sometimes that if only you had another chance, maybe you would have voted for another candidate who would have done better. Or do you sometimes feel let down by the person you cast your vote for? Now, imagine a situation where you could cast your vote during the entire tenure of a government on an ongoing basis, say every month? a general election every month! If this were to be true, how would things change? Since all of us have certain expectations from the candidates we cast our vote for, the ongoing elections will give us an opportunity to vote 'out' a candidate who does not meet expectations or shall we say fulfil the mandate1 and vote 'in' candidates who have a better chance of doing well. In other words, over a period, we will be able to weigh the candidates collectively, thereby recognising their true abilities to deliver on their promises to meet our expectations. As a result of this ongoing collective action, the candidate/ party that comes to power cannot take the mandate for granted. After all, if they do not fulfil the aspirations of the electorate that voted them in, they will soon be voted out of power! Hence, the steady state situation is that, at any given time, representatives who are best suited to meet the expectations of the people at large will be in power. Another supreme democratic institution - the stock market! The electorate here is the shareholder. The management of the company has the mandate to maximise the electorate's wealth. 'Wealth' - that is the operative word in this institution. Unlike the government where its actions help a country progress, and ensure the well being of all its citizens. The shareholder here parts with his 'capital' when he casts his vote to support a business that he expects will in the end grow his capital! Since there is wealth involved and the electorate's capital is at stake, his vote comes in the form of a 'price' he is willing to buy. A price that ensures maximisation of his returns on his capital! Unlike a once-in-four-or-five-years general election, the stock market provides the shareholders an opportunity to cast their vote every second, every trading day. An opportunity to price the businesses in terms of their ability to maximise wealth for them. Often bad businesses just get voted out of the market too! The collective action of these shareholders ensures that the businesses reflect their relative abilities to create wealth for their shareholders. Of course, one can infer at this stage that as the participants in the stock market increase to cover the larger part of the population, there will be convergence (since the word has become so popular) of what is good for the consumer and what is good for the shareholder. Anyway, that is a different story! The stock market: voting machine or weighing machine? "In the short run, the market is a voting machine - reflecting a voter-registration test that requires only money, not
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intelligence or emotional stability - but in the long run, the market is a weighing machine." - Benjamin Graham But does the market really end up being a 'weighing machine' in the long run? Between November 1999 and February 2000, any software stock you touched turned into gold. Let's take the instances of Infosys, the established leader, and Silverline Technologies, the desperate wannabe-Infosys. In November 1999, Silverline appreciated by 63% while Infosys appreciated by just 39%. The markets in their frenzy were bidding up Silverline expecting it to outshine Infosys. But did it mean that it actually did? Nope. The market realised its folly very soon, which is why between 1st December 1999 and 30th November 2000, Infosys appreciated by 57% and Silverline declined by 46%. Why did this happen? A temporary madness Take a look at the big picture for these two stocks? Chart 1 (Infosys)
In order to even out the fluctuations caused by the daily voting pattern of the market, we have taken the simple average of prices over the 30-day and 100-day period. Notice some correlation between the average prices and the profit growth of these two companies? Chart 2 (Silverline Technologies)
The growth in profits has dictated price movements or shall we say the market has recognised the stocks for their individual merits. Despite the fact that Silverline is in a high growth sector and has the advantage of being small sized, the company has compounded profits at 63% p.a. whereas Infosys has compounded profits at twice the rate (126% p.a.). By now, you know enough of compounding to work out what this differential can do over even a short period of three years. Hallelujah! Praise the stock market. It has it all figured out in the long run. It does get carried away sometimes but never fails to recognise its mistake and get back on course. In a very simplistic manner, we found for ourselves how the moving average prices over a period track the change in the underlying profits. Every participant casts a vote in the stock market every time they trade. There are a few people who keep polling everyday while there are the others who step in whenever they spot a distortion in the long-term trend of the business that provides an opportunity to make some big profits. Of course, many of you know these two categories of participants as 'traders' and 'investors'. Next time, we will understand these people a lot better. We will also understand why it is important to have more number of people and more number of shares to be traded in order to make the stock market an effective institution. 1.Mandate: an authorisation to act given to a representative
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Blame it on the big bad wolf?

Speculators prey on the small investor, or do they? Speculation. The word has a dirty twang to it. The speculator is bad. The small investor is good. Or so we are told everyday. The speculator is the Big Bad Wolf who preys on the Little Red Riding Hoods (read small investors) in the stock market jungle. This is popular perception. What surprises me after all these years of hearing this litany of complaints against the speculator is the ease with which the little ladies continue to enter and stay in the financial jungle. Actually, referring to the Little Red Riding Hoods as "small investors" might itself be misplaced. The term 'small speculators' might describe them better. Look at the reality - less than 10% of the traded volumes are settled by way of delivery and institutions account a significant proportion of such trades. In other words, even small investors are up to their neck in speculation. Unfortunately, Little Red Riding Hood does not seem to realise that it is not the Big Bad Wolf that is responsible for her problems. She is playing the game all wrong. And it takes some basic arithmetic to figure out the error of her ways. There must be some traces or scent that the little lady leaves behind in the financial jungle. After all, she is in the market already. Let's do the arithmetic behind the tr(e) ading pattern of the lady. For that we need some numbers, some averages. But we need not look far. The average trade value should be a good indicator of the appetite of the little lady (not the wolf). Based on last Thursday's data (and you can do this math based on the day's trade data published in any of the business papers) the average trade value of some leading stocks is as follows: Satyam - Rs1.13 lac, Zee - Rs0.75 lac, Infosys - Rs.1.28 lac and HFCL - Rs1.6 lac. Given that institutions trade in bigger ticket sizes, it is likely that the average value of the trades done by our little lady is even lower than average. So how much money does the little lady bring to the table? If we presume an average margin of 30%, then the capital that she brings to the table could be anywhere between Rs30, 000 and Rs50,000. Okay, that sounds small! But what happens when our little lady trades on this size (ie Rs50,000) of capital every day. Again apply an average brokerage charge of 0.1% and presume that the little lady trades her entire capital every trading day. She would incur a cost of Rs38,400 over the period of a year (240 trading days). In other words, she would start to break even only when she begins to earn 78% on her capital. She starts making money after that. My advice to the Little Red Riding Hoods of the world: it's not that the world is biased against you and is in favour of the Big Bad Wolf. You are playing the game all wrong in the first place.
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Red Riding Hood: Be patient

Research done on the usage of finance websites by the denizens of the Internet suggests that most visit the sites for just one reason, stock prices! Writing on Sharekhan we do often wonder whether the message that we are trying to send out is actually being heard. Or does it just lie there as some moralistic advice delivered from a high pedestal with no practical value? The last thing we would like the Sharekhan School to be is a textbook. A textbook that is considered to be full of theory and divorced from reality. That is of no practical value to the investor or to the speculator for that matter. The Sharekhan School is the collection of our experiences and learning. And we have not stopped learning, neither should you. So much for that emotional outburst! What, you may wonder, has led to such an outpouring on my part. Well, it has to do with the response that an earlier piece Blame It on the Big Bad Wolf? generated. In it I had argued that the reality of the market is that the small investor is actually a small speculator. Neither is she Little Red Riding Hood nor is the Big Bad Wolf (read Operators, Speculator) to blame for her woes. Little Red Riding Hood loses because she plays the game wrong in the first place. This led a Sheru, mhsmony, to state as follows: I quite agree with your statement that we play wrong game first time. But considering the stop loss, say, @3% how can one risk more than that? Should you conclude that this is not our cup of tea for small player and avoid the same? Could you suggest the no of trades and volume which will go a long way in helping the small investor? The article will be complete only then. Please advise mhsmony@yahoo.com Thanks and regards Yes, the reality is that there are a large number of speculators out there. I am not against speculation. Nor am I against trading. But there must be method in this madness. Particularly so because trading is a risky business to begin with -- one that is more often than not played with borrowed money (that is what trading on margin amounts to). It is a game in which the impact of transaction costs is often underestimated and worse still, ignored. The truth is that it does not matter whether you are a small speculator or a large speculator -- the arithmetic as I presented it in the earlier piece is the same for both (I'm surprised none of you pointed that out)! The bottom line of my point is that if you want to make money by trading, then you must realise that the key to your profitability is your "transaction cost" or in other words, the brokerage and other costs that you incur when you transact. The transaction cost eats into your trading profits and of course if you make only losses, then the transaction cost only adds to your losses. Unfortunately, it is this cost which more often than not is the cause for ruin for most speculators. That and the reluctance to follow the golden rule of trading: "Cut your losses, let your profits run". Success in trading rests on two issues: (1) your ability to follow this golden rule and (2) the transaction cost that you incur. And transaction costs are a function of the cost that you incur per trade multiplied by the number of trades that you do. Let us assume that you are able to follow the golden rule to the T and are also able to get the best possible deal on brokerage (per trade transaction cost). The only other variable that comes into play then is the number of trades you execute. The Big Bad Wolf in other words, ladies and gentleman, is trading more frequently than is justified. By trading everyday, as Little Red Riding Hood did in our fable, you are acting against your interests. You are allowing yourself to fall victim to the Big Bad Wolf because you have set yourself an impossible target -- that you will break even only after you have made 78% -- in the first
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place. Talk about losing the battle even before it has begun! My dear "mhsmony", unfortunately, I cannot offer a solution to your problem. It is not for me to tell you how many trades should be right. If you are a good enough trader to earn 150% a year, then by all means trade everyday. But if you believe you can hope to make only 50% before transaction costs, then you must inevitably conclude that you cannot trade everyday. In other words, you need to determine how often you will trade based on how much you believe you can earn. To trade more would be foolish. I have worked out a range of per trade costs and number of transactions in the table below, which will enable you to set the benchmarks. But the choice of what is right for you is a personal decision that you must make. I can only show you how the odds stack up against you.
Amount of capital Margin Value of trade permitted

Transaction costs -
Rs 1,00,000 33.33% Rs 3,00,000
No of trades per year 50 100 200 300
Brokerage rate 0.10% Rs 15,000 Rs 30,000 Rs 60,000 Rs 90,000 0.15% Rs 22,500 Rs 45,000 Rs 90,000 Rs 1,35,000 0.20% Rs 30,000 Rs 60,000 Rs 1,20,000 Rs 1,80,000
Value per trade - Rs 3,00,000

Spend a minute on the table. Infact spend more than a minute. Do you, in all honesty,. believe that you can make money even after incurring some of the huge transaction costs shown in the table? I hope this will help you reach an informed decision. I also hope this will sound a warning to the diehard traders amongst you to whom visiting your broker's office or trading over the Internet is almost a habit -- much like that morning cuppa. One last thought before I sign off ? While I have no statistical evidence, anecdotal evidence suggests that traders, who do not trade indiscriminately and instead wait patiently till the opportunity presents itself, tend to do better than those who trade compulsively everyday. Being patient and trading only when justified appears to improve your chances of making money in the first place.
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What ticks the stock prices?

The short story vs. the epic In the short run, stock prices are dictated more by market sentiment or demand-supply mismatches. But in the long run, stock prices value the earnings of the underlying business. "In the short run, the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long run, the market is a weighing machine." - Benjamin Graham If Thomas Alva Edison were a stock market analyst, he would have remarked that short run stock prices are determined by 99% sentiment and 1% fundamentals. On the other hand, stock prices in the long run are determined by 1% sentiment and 99% fundamentals. The two forces in play Since there are two broad tides that influence stock prices, it is logical that the participants in the market are broadly split into two categories: 1. Those who try to profit by swimming with the 'sentiment' tide that influences prices in the short run. They are popularly known as 'traders'. 2. Those who try to benefit from the 'fundamentals' tide that influence prices over the long run. They are popularly known as 'investors'. By now we know that prices in the long run track earnings per share. Of course, this is a fairly obvious conclusion - what else would one pay for? Every shareholder owns a part stake in the business and is thereby entitled to a proportionate share in the profits of the business. Traders and investors: spot the differences! Now imagine this: Given that stock prices track earnings over longer periods, if every participant turned a buyer for the long haul, how would the market subsist? Huh, so what happens to the traders? In such a scenario, what would distinguish a trader from an investor? A-ha, but that's not all - the plot thickens! What adds the interesting twist to investing in stocks is that earnings from a business are uncertain. They depend on many factors, some of which affect all businesses like an epidemic while the rest affect individual enterprises at a business level . In this manner, the interplay of these influential factors creates diversity of opinion, one of the basic requirements for a fair market place. Traders and investors alike cast their vote every time they buy or sell a particular stock. The stock price at every moment in time reflects the resultant of the collective action of the market participants at that moment in time. Differing reasons and bases for making a call Traders poll in everyday based on their judgement of how information on the 'factors of influence' will affect stock earnings and hence prices. After all stock prices are based on expectations of uncertain future earnings. As information flows in, the traders poll in to profit from short time gaps between reality and expectations. The only factors that keep changing often are the factors that influence all stock prices. Traders can only hope to maximise profits by trading as many times in the short run that will keep fetching them small time profits. Hence, these traders thrive on volatility. Buying based on mismatches in price and value 'Traders' as a class expect to be rewarded by the 'investors' for pricing the short-term factors of influence right! After all a trader has a position in a
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stock, hoping to profit from the short term mismatches. In the process, the trader hopes to get rewarded by the investor who helps offset the trader's position. On the other hand, investors buy stocks hoping to benefit from the growth in earnings. Hence they respond to factors that influence the trajectory of growth. Hence, the most basic style of investing will always be "Growth Investing"! However, there is another evolved investing style adapted by investors. There are occasions when there are large gaps between the value of a stock and the potential earnings that can accrue to the shareholder in the future. These gaps normally result from misunderstanding the business specific factors of influence and correct over a longer period of time. Investors poll based on these mismatches too. This style of investing is popularly known as "Value Investing". Of course, it is a difficult to clearly state who is a 'trader' and who is an 'investor'? A better way to distinguish them is from what tide they hope to profit from! The worst state is to be thinking like one and acting like the other. Time is another distinguishing factor A critical element that creates diversity of opinion and hence a fairer market is time. One, factors that affect businesses change over a period of time. Two, since traders and investors have different time horizons, their views on the impact of these factors of influence varies in degrees. Lost? Consider a sharp fall in Nasdaq in a single day. The impact of a sharp decline has a lot of effect on the short-term perception of Indian technology stocks. However, in the long run, the earnings of Infosys, say, is not impacted by a day's decline in the Nasdaq. Hence a trader is likely to react negatively to the single day decline in NASDAQ where as an investor would be unfazed. In fact, the 'value' investors will step in if the prices reach attractive levels, thanks to the terrified traders. However, a sustained decline in Nasdaq may have the potential to set panic attacks among the usually serene investors! Time is also the great leveller "Time destroys the speculation of men, but it confirms nature." - Marcus Tullius Cicero (106BC - 3BC) Time is the great leveller. Traders get to know soon whether they are right or wrong, but investors have to wait for a long time. Hence, 'humility' is a trader's virtue while 'patience' would be associated with an investor. We have covered a lot of ground in understanding the markets and its participants better. Though it seems that the existence of traders is essentially derived from the existence of investors, it is a symbiotic relationship - I scratch your back, you scratch mine! More on this later.
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Poles apart
The story so far? "Voting for Stocks" helped us in understanding that there is a method to the madness. Stock price movements though they seem fickle in the short run, track only the earnings per share in the long run. "What ticks stock prices?" established a clear demarcation between actions of traders and investors. Now it is time to move on? Why are trading and investing so very different? Is there a one fits all strategy for trading and investing? Or something even more basic? Are stock prices in the short run really 99% sentiment and 1% fundamentals? Remember the post-Pokhran market in May~June 1998? Take a look at what the prices of some of the leading stocks did after the market sentiment took a beating between May 20, 1998 and June 19, 1998.
Sensex HLL ITC Infosys Ranbaxy Satyam Pentasoft Zee
20-5-98 3957 164 822 637 323 56 523 51
19-6-98 3143 151 612 525 257 32 253 38
% Change -20.57% -7.93% -25.55% -17.58% -20.43% -42.86% -51.63% -25.49
Most stocks took a severe beating. The index declined by 21% and every stock from Infosys to Satyam declined between 20%~ 45%. All stocks came undone irrespective of which sector they belonged too. The market turned blind to the fact that the underlying businesses of these stocks had different potentials. A classic case of the market fury burning every stock in sight or should we say sentiment dictating 100% of the price movement. However, stretch the horizon from May 20, 1998 to March 5, 2001.
Sensex HLL ITC Infosys Ranbaxy Satyam Pentasoft Zee
20-5-98 3957 164 822 637 323 56 523 51
19-6-98 3143 151 612 525 257 32 253 38
31-12-98 3055 166 750 753 268 76 367 72
31-12-99 5005 225 665 7693 923 440 1336 1093
31-12-00 3933 207 895 5536 671 308 292 227
05-03-01 4003 226 741 4840 706 247 138 114
The picture tells us a different story. No points for guessing that the disparate prices of various stocks reflect the respective business potentials that got revealed a lot more in the intervening period.
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Interestingly, these stocks could have shown similar price movements for a brief period post-break out of the Kargil conflict or the debacle of the market in April 2000. One could also examine the recent washout in tech stocks and discover that a leader like Infosys and a third rung software stock met with similar fate. Just in case, you are wondering that sentiment wrecks havoc only on the way down. It has a similar impact during bullish periods! Clearly, the rules that govern prices during the short term and the long term are different. Imagine taking a trading position in Infosys for a week on May 20, 1998 after being impressed with the financials of the company. You still would have lost big money on your leveraged trading position. Similarly, imagine being bullish on the technology sector in May 1998 and buying a stock like Pentamedia. The stock is down from Rs. 523 to Rs. 138 where as an Infosys despite the recent carnage in tech stocks is up 660% since then! If pentamedia was the darling of the speculators then, here is another example of a low profile tech stock Tata Infotech (the stock quoted at 1133 on May 20, 1998 and trades at 163 in March 2001). A clear case that it is the merits of the individual stock that matters in the long run even during favourable times. Methods and means cannot be separated from the ultimate aim. - Emma Goldman (1869 - 1940) US anarchist All of us know that investing requires understanding businesses, projecting financials and evaluating the price of the stock vis-?is its potential, what is commonly referred to as 'fundamental analysis'. Trading is the trickiest of all. Since it involves dealing with fickle sentiments, demand supply mismatches over short time spans. Studying price/volume charts and trading with stop losses is critical. Disciplined application of the trading rules determines the ability to profit. Hence, the approach to trading and investing has to be very different. They can never be the same. As Rudyard Kipling said, OH, East is East and West is West, and never the twain shall meet, Till Earth and Sky stand presently at God's great Judgement Seat; But there is neither East nor West, Border, nor Breed, nor Birth, When two strong men stand face to face, tho' they come from the ends of the earth! He might as well have been talking of trading and investing in the stock market. An interesting question at this stage is should somebody new to the stock market start off by trading or investing in the market. Next time we shall answer this dilemma.
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Discount sale!
Upto 60% off on Arrow Shirts. Offer till stocks last! If you were to spot this in your city, it is very likely that you would have rushed to the shop to grab a few shirts. In fact, there are many of us who keep an eye for these kinds of sales to fill up our wardrobe. We don't even blink at the fact that lower prices increases off-take of goods. After all, classical demand supply equation in the real world dictates that demand increases at lower prices. Hence, prices at a discount to their perceived value should make merchandise move. In our case, it is the Arrow shirts. But do these market forces that we take for granted work everywhere? Stocks on sale Why are there no takers for stocks when stock markets crash? Why do market participants buy when the prices start appreciating? This strange behaviour of the stock market becomes painfully evident when the prices crash and there are no buyers
The obvious reason is that you buy a shirt for the value that it offers today not because you hope to sell it back at a profit to somebody else tomorrow. On the other hand, you buy a stock for its future appreciation in value. So when stock prices come off, there is always an expectation that they will be available cheaper tomorrow. Hence the successful purchase of a stock is one that appreciates today, tomorrow and the day after too! This uncertainty about future prices is what makes stock price behaviour very different from the real world. As a result, declining stock prices do not necessarily mean that buyers will flock in. Thus, in the stock market there are periods when there is a collective consensus that stock prices can only appreciate. These periods typically occur at the extreme of a 'bull market' (Remember Feb 2000?). At this extreme everybody wants to buy because it might be too late to buy tomorrow and nobody wants to sell. Similarly, there are periods of collective consensus that stock prices can only decline. Such periods typically occur at the end of a 'bear market' (Dec 1998?). At this point nobody wants to buy, they want to wait for prices to fall further before buying. And those who already own stocks want to get out so that they can get back in later and cheaper! For many of you this behaviour of the market is nothing new. However, this is an interesting corollary. If there is a collective consensus in the market on the future direction of prices either up or down, then that event is more unlikely to happen. Here is why? If 90% of the market participants think that all the stocks will be available cheaper the next day, then most of them would have sold the stocks they hold. They must be mad holding it when they are so sure! The smarter ones would have short sold. The next day there are only willing sellers and no buyers. All it needs then is one buyer or somebody to change their mind
Next time when everybody around you is sure that stock prices will fall further tomorrow and the day after, be ready to turn a buyer. But then how would you protect yourself from the uncertainty that could still persist? You can rein in the uncertainty by buying more than one stock. Basically, put your eggs in more than
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one basket. In fact, a big benefit of having a diversified portfolio is that the fortunes of your investment do not depend on just one stock. Hence, you would be more inclined to buy a beaten down stock, which could ultimately prove rewarding over time. Stretch your investment horizon A better way to reduce risk is to stretch your investment horizon. Imagine buying a good stock when everybody has turned negative on the market with a five-year horizon. There are scores of examples available. In fact 'Voting for stocks' highlights how the seemingly insurmountable short-term uncertainty disappears over the long term. The key is to always retain once perspective during extreme periods for the market. When everybody looks at stock prices trading at a steep discount and believes that they will get it even cheaper tomorrow is probably when you need to grab the offer.
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Regarding stock prices

What ticks the stock prices? A question worth all our capital. Earlier in school we sat on the shoulders of Benjamin Graham to understand that 99% sentiments and 1% fundamentals drive stock prices in the short run whereas 1% sentiments and 99% fundamentals dictate stock prices in the long run. Here is how the Merriam Webster dictionary defines "sentiment" and "fundamental". Sentiment: an idea coloured by emotion Fundamental: belonging to one's innate or ingrained characteristics Most of us find it difficult to believe that fundamentals really work in the market! However we stumbled on an event that can demonstrates that fundamentals really matter in the long run. It is an event of long standing nature that we presume most of us can relate to. It has to do with corporates being allowed to buy back their own shares. The Sensex trades at 3300 as dealers in hushed tones talk of a new law in the coming budget--buy back of shares. Gradually these hushed exchanges reach a crescendo and the market starts chanting, "buy back, buy back, buy back!" It appears all too easy. Buy shares from the market and sell it to the company.
The event unfolded
Traders have already identified their favourite buy back candidates: GE Shipping, Bajaj Auto and Reliance. All the three stocks rally with the market (check the respective price charts). But alas, the budget falls shy of introducing the bill that would have allowed these companies to buy back their shares. Chart: GE shipping
Then there's a change in regime at the centre. The "buy back" chants rent the air again. The new government is expected to announce a law allowing buy-back in the interim budget of June 1998. Speculation is rife again. But once again, the budget gets passed without any amendment to the company law to allow companies to buy back their shares. The Pokharan blasts take precedence over the budget. The market slips below 3000 and so do the prices of the three stocks. Chart: Reliance
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Finally on November 14, 1998, the law is passed that allows companies to buy back their shares. The market also registers a bottom around the same time. The Sensex rallies between November 1998 to February 2000, but apart from Reliance, none of the other two buy-back favourites--GE Shipping and Bajaj Auto--show any appreciation in price. In fact Bajaj Auto declines by 40% during the period when the Sensex posts a 100% gain! Chart: Bajaj Auto
In the end all these favourite buy-back candidates announce their buybacks. GE Shipping announced that it would buy back shares with an upper cap of Rs42 in October 2000. The stock price was Rs26 when the announcement was made. The company completed the buy-back in April 2001. But guess what? The stock never hit Rs42! Bajaj Auto's board approved the buy back on July 30, 2000 at Rs400. The stock price not only failed to touch Rs400 but it also declined once the offer period lapsed. Of course, it was not an open market buy-back. Reliance Industries proclaimed in June 2000 that it would buy back shares at Rs303. When it made public its buy-back intentions, the stock was trading at Rs340. Barely four months later the stock was at Rs287. Almost a year after it announced its intentions, the company has yet to buy back its shares. But the stock price trades close to Rs400 levels. In the end buy-back of shares turned out to be a big hype. So if it wasn't the buy-back event itself, what really worked for these three buy-back favourites? If you turn the clock back again, to the period between March 1997 and May 2001, you will notice the jigsaw pieces fall in place. The price patterns of each of these stocks tracked the direction of their respective earnings growth during the period. It is a reinforcement of what we already know but find hard to believe. That the market collectively gets carried away in the short run by ideas coloured by greed or fear, depending on the direction of price movements. However, in the long run, a stock price tracks the earnings of the underlying business or what we popularly know as "business fundamentals". In case one still has doubts, all one has to do is look at the price of Telco over a period of time. The great bull market of 1999-2000 barely had an impact on Telco's stock price, which continued to plunge with its sharply declining earnings. Chart: Telco:
The market was right
What is the moral of the story?
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Or for that matter take a look at the price earnings dance of Infosys. chart: Infosys
This behaviour pattern of the market is unlikely to change so long as we human beings make up the market. What is critical for an investor or a trader is to distinguish the short-term and long-term effects on stock prices and act accordingly. An investor with a long-term view cannot afford to get carried away by the impact of news on a stock price, just as a trader can ill afford to trade for the following fortnight based on what the earnings of the business would be for the following year. The other home truth on stock price behaviour to remember is that even in the short term the market is right about the impact of an event. However, the magnitude of the impact and its timing are the crucial elements that a successful trader/investor needs to keep in mind. Hence "price" and "timing" are always critical elements of any trading or investing strategy! For a trader, "timing" assumes priority over "price" whereas for the investor, it is "price" that is important. Of course many of you would have figured out why. Next time we shall look at these two critical elements in greater detail.
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I will thrive! Can you?

I was having a peaceful nap when I was rudely woken up? I got up rubbing my eyes to hear many cries of "July 2, 2001" July 2? I strained my ears to listen to people who have always been under my shade expressing concerns. It looked like they saw no future and had no option to do anything about it. They sure were lamenting! I cupped my ears to hear well. They feared that no 'badla' and introduction of options and futures was meant to destroy the market, ie cut my roots! Surprisingly, they were not shedding a tear for me but were worried about the fact that they will no longer have the shade! How self-centred can one get! I opened my eyes wide enough to look at who were actually wailing. They all were fat people who had merely played under my shade and at times hurt my roots. In fact, they made use of a creeper 'badla' to climb up and dance on my slender branches that were meant to further my growth. But let me assure I have been around for a very long time. I have seen many people come under my shade, and fruits have grown every season on my branches. Oh! Before you confuse me for a giant mango tree and wonder what am I doing here in Sharekhan School, let me introduce myself. I am the "Indian stock market" I am over 200 years old and possibly the oldest one in Asia. My initial history is obscure. The English (East India Company), who came to India to trade, planted the seeds of my future. By 1840 (a good 160 years back), there were registered companies trading in the market with half a dozen recognised brokers. By 1860, there were 60 brokers! In fact, the first stock market mania in India happened then. The civil war broke out in the US and India was the only supplier of cotton to the world! By 1861, there were 250 brokers . Guess what happened next? The civil war ended in 1865 and there was a big slump in the market. The Bank of Bombay share, which traded at a princely price of Rs2,850 crashed to Rs87 in no time. I survived that mania and God knows how many more after that? After the slump, the brokers decided to regulate themselves. As a first step, they moved in together to stay as a flock on one street--that street is today known as "Dalal Street". Year 1899 is when the Bombay Stock Exchange was formed. You must have come here hoping to learn something and I have been just rambling. Without much ado, here are
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some facts and figures that I shall use to make a few points to you today. Here is a comparison of statistics in 1946, the earliest available statistic and statistics for 1995, the latest available. I know 1995 is still outdated but it helps make my point.
Capital of listed Companies (Nominal) (Rs. Crs) Capital of listed Companies (adj Inflation) (Rs. crs) Market Value of Capital listed (Nominal) (Rs. crs) Mkt Value of Capital listed (adj inflation) (Rs. crs) No. of listed companies Capital per listed Co. (Nominal) (Rs. lakhs) Capital per listed co. (adj Infl) (Rs. lakhs) Market Value per listed co. (Nominal) (Rs. lakhs) Market Value per listed co. (adj inflation) (Rs. lakhs)
1946 279 4431 970 15919 1125 25 407 86 1415
2000 59583 59583 478121 478121 8593 693 693 5564 5564
CAGR 11.32% 5.33% 13.20% 7.04% 4.15% 6.89% 1.07% 8.69% 2.78%
The number of listed companies is up eight times in 50 years. Inflation adjusted for these fifty years, the capital raised is up 13 times while the market capitalisation is up a good 30 times. Isn't it a sign that I have done very well over these years serving corporates that hope to raise capital for their businesses as well as investors who invest in these companies? Of course, in the interim period, most of the originally listed stocks have all disappeared, but the fact that investors who managed to pick the survivors every time would have made 8.69% per annum return or 2.78% inflation adjusted return. That's not much, you would say? Well, if you had invested Rs1,000 in 1946 it would have been Rs65,000 after fifty years. But Rs1,000 fifty years back is not equal to Rs1,000 today. In fact, what Rs1,000 was worth fifty years back would be worth Rs16,000 today. Even then, it would have quadrupled. Can you think of any other way you could have done this over the last fifty years when this country saw an average inflation of 6%? Apart from the last ten years, India ever since Independence followed a socialistic path that stunted my prosperity. True that there is no guarantee that any institution that has survived for over 200 years will necessarily survive the next 200. After all, even the great civilisations that we read about in our history books came to an end. Why else would they be in a history book?
But I have been changing. Derivatives are another way that will help me to serve my purpose better. It has worked in stock markets across. Mind you, it is nothing new here too. We used to have 'Joota' and 'Phatak' here. What has changed is that there is a lot more science now. Black & Scholes worked out a formula for pricing 'options' that is complex sure but in the world of technology you have calculators that just fetch the price for you. After all, I did exist before people knew 'P/E' and I existed before people discovered 'PEG' too. How long has it been since Ben Graham worked out a classic style of investing or a Phil Fisher evolved his own style of investing? These are all examples of investors evolving to make better investing decisions that help them create wealth for themselves on a consistent basis. We all need to evolve. I am changing for the better. Earlier, investors had to invest and manage the uncertainty of their investments in the same place. Spotting the dilemma of the investor, speculators came up. Initially, it was a symbiotic relationship till the balance broke. Obviously, with little at stake compared to an investor, the speculator made merry.
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The investors scurried for cover. But when the investors started disappearing, without them the speculators had to feed on each other and thus their race started dwindling. After all, the investors who were the very basis of their existence disappeared.
They offered to move to the neighbouring compound in order to allow the investors to thrive and thus was born the derivatives market. In case you are wondering who does the balancing act now, well they are called arbitrageurs. I am evolving! Are you? If you have no intentions, please don't wail either. Just pack your bags and don't waste my time. You are keen to evolve? I am very happy and you are my friend. Come let us prosper together. I rest my case.
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Time to take a break from the classroom. Time to share some experiences and have some fun. Investing in stocks is a serious game, know your rules before you break it. Chapter 1: Market Memoirs Chapter 2 Chapter 3: Analyst Memoirs Chapter 4: Market Lore
Share the experiences of many a different investor... Article 1: Janus faced volatility | Understanding how investors and traders come to terms with volatility. Article 2: Adventures of a novice investor | Jan 1 2000 Is "how to buy" as much an issue with you as "what to buy"? Some ABCs... Article 3: Mangoes vs potatoes | Mar 18 2002 Why are mangoes costlier than potatoes? Boy! Oh, boy! That is a real tough one. Article 4: Beware the tipsters | Jan 7 2000 Some true stories about how people lost money because they got carried away. But learn from mis... Article 5: You've come a long way, baby | Jan 7 2000 Today's shareholder has a far greater say in his company. And AGMs provide just the right platf...
Chapter 2: Investor Memoirs
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Article 6: The Key | Nov 4 2000 Tune in to find out what an old Buddhist saying has got to do with investment philosophy Article 7: Soul-searching time | Oct 24 2000 Time to clean up the skeletons in the cupboard... Article 8: Back to basics | Nov 7 2000 Coming to terms with the simplest truth of investing Article 9: Financial Resolutions for the New Year | Jan 1 2001 The ten resolutions a serious investor like you should be making for the New Year... Article 10: Vision + Strategy | Feb 19 2001 What does Thomas Alva Edison have in common with Azim Premji? Article 11: No green thumb | Jun 5 2001 If watering the plants everyday is not your cup of tea then you must search for the plant that ... Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Investor Memoirs Getting Started - How to Begin Investing Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
Janus faced volatility

Here is the essence of the wisdom that we have picked up along our journey to this stage. Stock prices are predictable with larger degree of certainty in the long term Traders attempt to profit from 'sentiment' and investors profit from the 'fundamentals' of the business Hence 'trading' and 'investing' need diametrically opposite approaches, attitudes and horizons Let us begin the next leg of our journey by answering a simple question. As an investor, which stock would you rather own?
Stock ABC Ltd. that goes up 100% in year 1, declines 40% in year 2, gains 100% in year 3 and drops 50% in year 4.
Stock XYZ Ltd. that advances 5% in year 1, rises 5% in year 2, gains 5% in year 3 and increases another 5% in year 4.
Doesn't ABC Ltd. seem the right stock to invest? After all, a simplistic calculation of average returns every year for ABC Ltd works out to 27.5% (200% minus 90% divided by 4). Where as for XYZ Ltd. the average annual returns works out to 5%. Most of us who wish to be investors make these simplistic calculations and decisions to chase big winners at times without realizing that there is a big risk we take as investors. Let us assume we invest Rs100 in ABC Ltd. After year 1, the investment goes up to Rs 200. In year 2, it will drop to Rs120 (declines 40%). Year 3 is a good year and the investment grows to Rs 240 (gains 100%). In year 4, the investment in ABC Ltd is worth Rs120 (50% in year 4). Imagine, you invested Rs 100 in XYZ Ltd. Year 1, it would be worth Rs105. Year 2- Rs110.25, year 3Rs115.75 and at the end of year 4, you would have made Rs121.5. This way you actually end up making more money than ABC Ltd. Would it change if you were a trader? Obviously, yes! Imagine buying ABC Ltd for Rs100 and selling at Rs200 in year 1. Selling short Rs200 worth of ABC in year 2 to make a cool profit of Rs80 (a decline of 40% on Rs200). Then in year 3, buy Rs 280 worth of ABC Ltd and sell it to realize Rs560. Short ABC Ltd in year 4 to make a profit of Rs280. Wow, a cool profit of Rs740. Whereas in XYZ Ltd, you as a trader would have still made a profit of Rs21.5
The learning: Volatility in stock prices presents an opportunity to a trader whereas it is a threat to an investor. Another fact that demonstrates that trading and investing are poles apart.
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A short break in our journey to spare a moment understanding how the investor grapples with the threat of volatility. Of course, stretching the horizon of investment helps an investor turn a blind eye to market storms. There are three active ways of handling volatility. Asset allocation or in other words the way you distribute your wealth between stocks, real estate, gold,fixed income securities (like bonds, deposits) and cash. Portfolio diversification helps handle risk too. Steady investing or spreading investments over a longer time frame is another way of smooth sailing in turbulent market waters. Time now to prepare a ground to move on? You are new to the market. You are standing at a junction. You now have these options. At the primary level, you can either be a trader or an investor. At the secondary level, you can pick between a stock like ABC Ltd or XYZ Ltd. Earlier, we have worked out that, as a trader you could have a maximum profit of Rs740 if you were trading ABC Ltd. If you were trading XYZ Ltd., you would have earned Rs21.50. Alternatively, as an investor you would have raked in profits of Rs20 in ABC Ltd and Rs21.5 in XYZ Ltd. We have represented the profits as a matrix below.
ABC Ltd. Investor Trader 20 740
XYZ Ltd. 21.5 21.5
Clearly, the maximum profit of Rs740 trading in a volatile stock like ABC Ltd stands out as the best option. Most new comers to the market make these mental calculations and jump at the option of being a trader in ABC Ltd. Is it the right choice? As Alice would ask `Would you tell me which road leads out of the wood?' The cardinal mistake most newcomers to the market make is that they assume they are taking the risks of an investor in XYZ Ltd. when they trade in ABC Ltd. in search of the maximum returns. However, we are all a lot more knowledgeable now. We know how the Janus faced volatility means two different things to the investor and the trader. We also learnt at the beginning of the journey that unpredictable sentiment rules stock prices in the short run whereas predictable business earnings dictates prices in the long run. Many of you would have already resolved the dilemma. Next time we shall address this in greater detail.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page As I sat scratching my freshly tonsured head, with the princely sum of Rs2000 warming my lap, it occurred to me that I should invest this in the stock market. So I promptly applied for the next IPO that I stumbled on, and as luck would have it, was allotted shares. The company? XLO Machine Tools. You know how the rest of the story played out, I?m sure. No dividends to date, but I receive balance sheets dripping red ink every year, on the year. Needless to say, that was the last time my Dad let me have my way with money, for a really long time. I finished college (B Com), worked for a year as a writer in an advertising agency, went to business school to study marketing & advertising, worked in advertising and television for the last 7 years. Neither my B Com nor my MBA gave me any confidence to attempt re-entering the markets. In fact, until I got married, I didn? t save any money, and after I did, my wife took my money and put it in UTI?s MEP, LIC, IDBI?s bonds & so on. Then I met a friend who works for a stock-broking firm. (Should have his head examined, I thought !) Soon, however, I started reading their research reports. And inevitably, I got hooked. It all sounded so exciting. Infosys should actually be valued at Rs11,000! Lakme gives Rs110 profit in one month! Ramco gives Rs114 profit in 3 days ! All this was too much for me! I had to get on this bus, before I missed another small fortune. But you know how it is. Though I understood that a small investor like me should begin by buying something safe, like Levers or Infosys, I didn?t. I mean, who?s got a couple of lakhs to put in a safe stock like that, right? (Of course, what I didn?t know then, but do know now, is that I could have even bought just 10 shares of Levers if I wanted, since it is a compulsory demat stock). So I waited for a real bargain. And it wasn?t far away. J K Chemicals at Rs10. Rs 10! A secondary market stock available at par value! And I knew a little about brands and all that, so the Park Avenue story made sense. I asked around for some names of brokers, picked one who had e-mail (I wasn?t sure what one is supposed to say on the phone, and thought I could avoid getting embarrassed if I e-mailed my orders) and dashed off a note asking him to buy me a 1000 shares of J K Chemicals. And then I waited. And waited. Two whole days went by. My mailbox stayed stubbornly empty. Meanwhile, I learned that the scrip had scorched away to Rs15 already. Damn, I thought. If only I had ordered 5000 shares instead of 1000. I?d already be richer by Rs25,000. In just two days. Imagine that ! I lost myself in a daydream, buying expensive gifts for everyone, and basked in the warmth of being able to tell my father that my second investment decision in life would more than make up for the first mistake. The jangle of my colleague?s telephone ringing broke my reverie, and I reluctantly returned to grim reality, and faced up to the awkward task of speaking to my broker. Guess what? He said that I didn?t specify that he should buy J K Chemical at any price possible, so he assumed I wanted it at Rs 10 or below, and he couldn?t get it, so he didn?t. Who was going to tell me that I am supposed to specify all this stuff, I wanted to ask him. What I did ask him was why he didn?t call or mail me to inform me about this for two days running. His answer was simplicity itself. ?Saab, kam hua nahi, to khali fukat phone kayko karke aapka taim barbaad karoon?? Lesson one in investing. With your instructions to buy, specify whether you want to buy within a particular price limit, or at whatever price the scrip is available. (I believe the jargon for it is limit order or market
Getting Started - How to Begin Investing Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
Investor Memoirs
Adventures of a novice investor

Once upon a time, when I was in class IX, my parents had my thread ceremony done. I was young (all of 14) and idealistic, so I participated very grudgingly. As a pacifier, my parents let me decide what I wanted to do with the gift money I received.
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order, respectively.) Even more important lesson one. Find a broker who will serve you well, viz., call or e-mail you for clarifications, for information, for confirmations. You?d think I learnt my lesson and changed my broker. Well, not exactly. Its not like my job leaves me much time to do all this stuff, and he had been recommended by someone I trusted?who was it now? anyway, too much of a bother, so I let it be. Another story caught my eye. Mastek. Sounded like an Infosys in the making. At a throwaway price of Rs988. Well, not throwaway for me, but it seemed like I wasn?t destined to get a good stock at Rs10, so what the hell, I thought, let?s give it a shot. Of course, I just had Rs50,000 to spare at that time, so I shot off a mail, asking my broker to buy me Rs50,000 worth of Mastek. Remember Levers? You can buy even one share, blah blah blah. Of course, if you?re wiser than I am at this, dear reader, you know that Mastek isn?t a demat share yet, so I couldn?t have got 50 shares for love or money. This time, my broker did call me to tell me about my folly, but at the end of the day. By which time, as you?ve probably guessed, another bus had left me standing at the stop. Lesson two in investing. Find out if a scrip is demat before ordering odd numbers of shares. Never say die is my motto. So, when I read a report on the Polaris public issue, which said it was worth investing in, I enthusiastically got the forms. But the zillion boxes that needed to be filled were too daunting by half. Result? No deal. By now, you must be thinking I still don?t own a single share, right? Wrong. I finally managed to buy my first stock. Citicorp Securities. No, I didn?t read any research report on this one. My friend at the broking firm said that his gut feel about this stock was very good, they were doing something that Business World did a cover story on, et cetera. Okay, I said. Let?s go for it. And picked it up at Rs250. Then suddenly one day I woke up to discover that the price had plummeted to Rs210, and it looked like it would keep going south. This, in a market whose index was racing up so fast, Mt. Everest would?ve got a complex. Naturally, I panicked. My friend at the broking firm was suddenly caught up in a whirlwind of meetings, and didn?t respond to the 53 calls I made in 3 days. And here I was, left holding the baby. Frozen into inertia, much like the rat who?s just spotted the raised hood of the cobra towering over him, I did nothing. Fortunately for me, it all worked out in the end, and as soon as it touched Rs 275, I sold the scrip. Of course, I am looking a little foolish, since Citicorp is still riding the up elevator, but doesn?t matter; I saved my skin, right ? Lesson three in investing. Don?t buy on tips, because tipsters might turn out to be fair weather friends, who scurry into hiding at the first sign of trouble. Don?t feel sorry for me. I made a killing on the market last week. Let me tell you how. The other day, I went to my ATM to withdraw some money, and saw a notice there that said I could now pay my phone bills, my electricity bills and my credit card bills through the ATM itself. Wow, I said to myself. I work long hours and Saturdays, so it?s almost impossible for me to go to the bank for any work. And know what, ever since I opened an account at HDFC Bank, thanks to their superb ATM service, I?ve not needed to meet anyone at the bank for anything. I do all my banking in the middle of the night or on a Sunday, without a problem. Then I got thinking. I tried to remember why I picked HDFC Bank to bank with. Basically for the ATM. But why not any of the other banks which had ATMs? The foreign banks intimidated me, and I?d heard they need huge minimum balances. Between ICICI, IDBI & HDFC, the first two smelled of government, so I wasn?t too confident of their customer service orientation. Whereas, HDFC had been serving middle-class people like me for many years, financing our homes. When the machine spat out my crisp 500 rupee notes, my flashback ended. And I thought, all the reasons I picked HDFC as the bank to bank to with, are equally good reasons for buying into their business. Then I looked to see if any broker had any research on it. (See lesson three). After finding a report that confirmed my faith in the stock, I bought at Rs87 last week. And it?s already at Rs99. So, all?s well that ends well. My adventures in investing have taught me a lot. And whetted my appetite for more. To me now it?s not so much a pursuit of wealth, though that?s part of the agenda. It?s more a process, a journey, an exploration and a learning experience. In the bargain, if I make some money, that?s icing on the cake. What are you waiting for? Come, join the adventure!
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page The other day I took my 6-year-old son shopping. He is at that age where he asks questions which stump fathers the world over. After running through my better half?s shopping list, we headed back to the car. No sooner had I fastened the seatbelts he piped up in his Why is tone: ?Dad, why is a kg of mangoes costlier than a kg of potatoes?? Boy oh Boy. That is a real tough one. ?Son, it costs more to grow the mangoes than it does to grow the potatoes.? Even as those words slipped out of my mouth, I remembered my management textbooks. The producer sets the price based on what the consumer is willing to pay. The consumer pays based on the utility, satisfaction and pleasure that he gets out of the product. All about utility, satisfaction...and pleasure So it cannot just be the cost of production that makes the price of mangoes higher than that of potatoes. Come to think of it....that?s true in the stock market as well. Why does Infosys trade at Rs7000 and ICICI Bank at Rs36. They are as different from each other as mangoes are from potatoes. Would you go home with a sackful of potatoes, instead of a basket of mangoes, just because they cost less per kg. Unlikely, In fact, I would wager that you would never dream of doing any such thing. Then again, you might--if you are a miser. But would you and your family get the same utility and satisfaction? Not to forget pleasure? It is quite the same thing in the stock market. Rs36 does not make ICICI Bank any cheaper than Infosys at Rs7000. Fine, you might want to buy a Banganapalli instead of a Apoos. If you are from Bombay in all probability you value a Apoos higher (in terms of taste and satisfaction) than a Banganapalli. So you might pay a higher price for the Apoos. It?s the same with stocks too At the end of the day, you pay for the utility value, satisfaction and pleasure that you derive from it. The satisfaction, utility and pleasure that you derive from mangoes cannot be quantified in numbers, at least not easily. Thankfully, in the stock market there are a large number of measures that tell us exactly what we get when we own a share in a company. For example, you can look at the Earnings Per Share (EPS), i. e., the profit earned by the company/per share. That?ll tell you how much of the company?s profits belong to you as the owner of a single share. You can also look at the Book Value Per Share (BV). That is nothing but the company?s Net Worth (funds which belong to the shareholders as opposed to the debt it might have taken) attributable to each share. How much the company earns on your money is another benchmark. That is Return on Net Worth (RONW). Very simply, it is EPS/BV. After all, if a company has a RONW of just 10%, it means it is just about matching the return you could get by putting your money in a plain vanilla fixed deposit with a bank. Let me spell out what I am getting at. Do not presume that something is cheaper, and therefore better, just because its price is lower. You need to look beyond the price to see what is it that you get for the amount that you are paying. The root cause of this perception problem is the concept of par value. I have heard this argument before. Why should I pay Rs7000 to buy a share of Infosys. The par value is only Rs10. Why not buy ICICI Bank? Its par value is the same and its price is only Rs36. Let me counter. Of what relevance is the par value to you? Nothing. If the company goes bankrupt, is that a guaranteed amount that is returnable to you? NO. Sure, companies still announce dividends based on a percentage of their par value, but is that why you really buy shares? To earn a dividend? Investor Memoirs Getting Started - How to Begin Investing Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
Mangoes vs potatoes
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Who are you kidding? You buy it for capital appreciation Don?t let high stock prices bring you down Think of a share as representing a certain percentage of the company. If a company has issued 100 shares and you own 1 share, then your share represents a 1% ownership of the company. Sure, in most cases the shares we own make a meaningful percentage only if you go down to the 5th decimal place. But that is what is relevant. How much do you think the company is worth and how much would you pay for acquiring a certain percentage share of it? Think of it that way and things will fall into perspective. The fruit seller in the market had a basket of mangoes which cost Rs100. I could either pay the fruit seller Rs100 by giving her a hundred rupee note or with two 50 rupee notes. Better still, I could pay her Rs50 and buy half the basket. And somebody else could pay her Rs50 and buy the other half. But that doesn?t make the mangoes any cheaper for me or the other guy, does it? Let?s put it another way. Say a company is worth Rs100 and you wished to buy 5% of that company. It would cost your Rs5. If the company had 100 shares outstanding, then that would place the value per share at Re1. You would then have to buy 5 shares to buy 5% of the company. Now let?s presume that a company has only 50 shares outstandings. Now that would place the value per share at Rs2. You would have to buy 2.5 shares of the company, entailing an outlay of Rs5 yet again. In both cases, you just spent Rs5 to buy 5% of the company. So, was it any cheaper to pay Re1 per share than it was to pay Rs2.5 per share? I can hear my son again: ?Why is a kg of mangoes costlier than a kg of potatoes?? Still need to find some way of explaining this to him!
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Beware the tipsters

August 25,1999: The telephone rings in Vishal?s office. Vishal is a chartered accountant with a small time finance firm. Vishal answers the phone and listens to the excited voice of Vaibhav, his school time buddy who regularly trades in the stock market. Vaibhav peddles stock tips. A few months back, he had called up Vishal and asked him to buy Himachal Futuristic Communications, Global Telesystems and BPL. Vishal refused to act on his advice. Since then, Vaibhav had called up a number of times to remind him that his tips had turned three-baggers! Vishal regretted missing out on these ?get rich quick? tips, especially since everybody in his office spoke about all their multi-baggers everyday! Vishal: ?Hi Vaibhav, Kya kar...? (before he completes his sentence Vaibhav interrupts in an excited tone) Vaibhav: ?Aditya Forge, Kunal Overseas aur Jaidka Industries le le. Don?t worry about your missed chances; these three will more than make up for them. Chalo baad mein baat karta hoon? (He slams the receiver down) Vishal gently places the phone down, caught in a whirlpool of thoughts. He bites his nails as he ruminates whether to buy these hot tips or not. After half an hour, he decides to call his broker. Just as he reaches for the phone, the receptionist in his office calls up to announce that his brother Ramesh is here. Ramesh was an avid stockmarket participant in the heydays of the early 1990s. After the scam, he lost his last penny. Ramesh ended up owning a lot of penny stocks, which were not worth the paper they were printed on. Ramesh went through very tough times when he had to move with his family to his father?s place. He had to sell off his car and 3 bedroom flat in Bandra, Mumbai. His wife had to take up a job as a secretary in an Ad agency. Ramesh started working as a clerk in a bank... Vishal: ?Bhaiyya, good that you came. Remember I was telling you about that school buddy of mine, Vaibhav, who claims to have made lot of money in stocks. Well, he keeps calling up to give me stock tips. I refused to act on his earlier calls but they have all multiplied. He had called up just a few minutes back asking me to buy Aditya Forge, Kunal Overseas and Jaidka Industries. I always remembered your experience so I held back, but then I seemed to have missed out. Bhaiyya, advise me. Ramesh: ?Reminds me of the good old days in 1992. I used to trade on tips too. When the market was going up, all these stocks were going up five times. I had quite a few stocks, like Karnataka Ball Bearings, Mazda Leasing, lots of NBFC stocks. At the peak of the market, my portfolio was worth Rs40lac. I then borrowed money against these stocks and bought more. In fact, I had bought Aditya Forge and Jaidka Foods (Industries now!) then based on tips I had got.? Vishal: ?Bhaiyya, then what happened?? Ramesh: ?The scam broke out and all hell broke loose. My portfolio, which was worth over Rs40lac, reduced to Rs4lac in just a month. There were no buyers in my stocks. I had borrowed Rs10lac and I had no money to pay. I tried selling my flat but there were no takers. I was saddled with stocks of companies that I knew nothing about. After I paid off my debtors, I tried getting a number of these stocks transferred in my name so that I could sell them when times got better. Much to my dismay, I discovered that many of them did not have offices and were shell companies. I had bought Aditya Forge at Rs26 on a hot tip and found that I had created the top, while it currently trades at Rs2! Jaidka Foods dropped all the way from Rs40 to Rs1.40.? Vishal: ?You have started trading again. What do you advise me?? Ramesh: ?Vishal, these days I invest. I am really not bothered about the Sensex level, but I probe deeply into the companies that I invest in?their management, their business and future prospects. I buy specific stocks that I understand and I believe are undervalued.?
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Vishal: ?But those stocks offer very very gradual appreciation.? Ramesh: Not at all, Vishal. My portfolio of fundamentally strong stocks has done quite well for me. I bought Zuari Agro at Rs69 fifteen days back and the stock has doubled since then. Many of the stocks have gone up faster than I expected?Tata Honeywell has nearly doubled since I bought it two months back and so has Indo Gulf Corporation. Very often, I too get good information about a company; but you must always cross-check the information. You may listen to tips, but understand very clearly that you need to understand the details of the company yourself.? Vishal: ?But Vaibhav is a good friend of mine.? Ramesh: ?If you are to follow Vaibhav?s advice, then you need to at least check how much research Vaibhav himself does before recommending a stock Most tipsters are fair weather friends who are around whenever markets are buoyant, palming off their tips. However, when it is crunch time they all disappear, leaving you stuck with all the dirty stocks. I have had this experience before. Remember, the market thrives on two basic human emotions?greed and fear. Always learn to strike a balance and do your homework. If you are so keen to invest, I will put you on to this brokerage house that offers very sound advice...? Vishal: ?That would be very useful.? Ramesh: ?Vishal, I have been through very trying times investing on tips. So don?t let there be another such occurrence in the family. Papa invested in teak farms and you know the state of his finances. Kaka chased those ?time share? investments and lost out. There is nothing like ?get rich quick?. It is usually ?get rich quick, get poorer quicker?.? (While this story is a piece of fiction, some of the stocks mentioned in this story were actually bought by people in this office way back in 1994. We all get carried away; but to not learn from our experiences is criminal. Many of the people in this office who bought some of the above mentioned stocks are now much more sober, if not wiser, and thought they should share their experiences with you.)
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You've come a long way, baby

The last five years may have been frustrating years for stock market participants as they witnessed large scale evaporation of inflated wealth. However, there?s a lot of good that has come out of these excruciating times. The markets have evolved to become more efficient, transparent and liquid. Indian corporates that took the investors for a ride have been forced to eat humble pie. Investors who got short changed have since woken up to reality and have learnt to fight for their rights. Annual Shareholder Meetings of corporates, AGMs as they are popularly known, provide excellent opportunities to understand companies, management and shareholders. AGMs over the last five years have been a great vantage point to observe and understand the Indian stock markets, investors and corporates coming of age. Through the eyes of Ms. Ashalata Maheshwari. Ms. Ashalata Maheshwari is an old lady who has been a shareholder in many of India?s family run companies. She religiously attends all AGMs and makes it a point to be one of the first people to walk up to the podium to pose questions to the board of directors. So much so, that today she is an integral part of AGM folklore and the first thing that the Chairmen of these companies do is to scan the crowd to find her and give a smile of recognition. July 1995 (Corporate results were on the rise, FIIs had just debuted, the IPO market was booming) Ashalataji: Chairman Saab, Hamara reserves has grown. You should declare a liberal bonus to please shareholders?your staff made me wait for five minutes outside. The sweets being served got exhausted too soon. You should get more next time? Chairman: Ashalataji, we just declared a bonus last year. As for the rest, I will request the secretarial department to look at it. July 1996 (Corporates had just declared record profits. Equity research had gained currency on a large scale. Stock markets were range bound with the large number of IPOs taking its toll on small cap stocks) Ashalataji: I would like to congratulate the Chairman for the superb performance. Hamara company ka ? eps? is very good but our P/E is lower than last year. What is the FII holding in our company? We should increase our FII ceiling. After such a good performance, Chairman Saab, you should declare a bonus? Chairman: (A large smile on his face) Our FII holding stands at 19% compared to 5% last year. We have organised an analyst meet next month. We are in the midst of a major capacity expansion and cannot afford equity dilution? July 1997: (Inflation taming had led to a Liquidity squeeze, trapping corporates. FIIs had seen their investments erode. The Reliances and Telcos had fallen sharply. Investors had stopped looking at ?Bhav Copies?.) Ashalataji: Chairman Saab, Why has our share price fallen by 40%? Is our new plant operational? Why don? t you organise a plant visit? By the way, we did a good thing by not declaring a bonus. Our share price would have gone down further! Chairman: (visibly perturbed by the tough times) We have increased market share in these trying times. Our plant commissioning has been delayed by few months and the project cost is higher than estimated. Our borrowing costs have increased while demand has not picked up yet (As usual, circumstances were blamed) Hopefully things should improve by the end of the year (Hope!)
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July 1998: (A new BJP government had not improved the situation. Industrial Sector had barely managed to grow in the previous year. Post the South East Asian Crisis and post Pokhran, the FIIs had dumped stocks. Shareholder wealth had been eroded) Ashalataji: (A furrowed forehead) Chairman Saab, We have performed very badly. If our cement and sponge iron business is not doing well, why should we have it? Hamara ?core competency? hai textiles (?) Our market share has gone down. Who is our competiton? This years annual report, pg no. 38 shows travelling expenses doubling, pg no. 36 our sundry debtors have increased by 50%.Aur Chairman Saab, aapne tho employee salaries increase kiya hai, lekin our dividend has not gone up... Chairman: (A forlorn face and at a complete loss of words) Ashalataji, our country has been in a recession. We should be seeing a recovery soon. (Going on the defensive) We have done well against stiff local competition. We are only getting hurt by cheap imports from Taiwan. (Uncomfortable answering the remaining queries, the Chairman quickly turns to another questioner) July 1999: (As 1998 turned out to be difficult, corporates paid through the nose to hire consultants. They recommended focus on core competency, selling off unrelated businesses (Where have we heard that before ?) Survival instincts forced corporates to shape up. Recession had halted capacity addition. Banks were flush with liquidity while NPAs grew.) Ashalataji: (Forgiving mood) Chairman Saab, our cost cutting measures seem to have paid off. Aapko badhaiyan.. Thank you for the plant visit. Our plant is very impressive. I agree with your statement in the annual report (actually penned by the consultant) that we need to focus on our core competency and build a brand equity by adding value to our products. (She has rehearsed this!). Dear Chairman, we should disclose in our annual report our EVA and the historic Return on Equity. We should also adopt GAAP. Our annual report should also disclose information on the company?s long-term vision and strategy. Sir, Hammne Kargil ke liye big donation kyon nahin kiya hai...(social responsibility of corporates!) Chairman: (After a quick discussion with his fellow board members) Ashalataji, you are absolutely right. We have decided to give one day?s profits to the Army. You are also right on the EVA, from the current year our business performance will be benchmarked on EVA basis. Next year,we will also report results as per US GAAP. The Indian Investor has arrived, the corporates are catching up?
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The Key
To every person is given the key to the gates of Heaven; the same key opens the gates of Hell an old Buddhist saying
You may want to rightly raise your finger at me and ask the question - what does this have to do with equities, with the stock market? We hear stories every day about people, flesh and blood human beings - our clients who have lost money in the recent crash. And I hear many questions. Is the stock market a gamblers den? Can one actually make money? Is it for the individual investor? Given the kind of volatility one has seen in the market does it really make sense to invest in the market for a long term? In a sense equities are like the key in the saying I need not remind you that equities as a class provide a much higher rate of return than fixed return instruments. It is the key to immense wealth creation. But use the key wrongly and with the wrong objective and you can find yourself opening the gates to an investor's version of hell. What we need to do is distinguish between the gates of Hell and the gates of Heaven. And learn how to use the key correctly. Because using it correctly ensures that we find ourselves in front of the correct gate. From a distance the gate to Hell is arguably more attractive - it promises quick returns based on speculative and 'Inside' information resulting in gain without pain. It is with good reason that this gate is more attractive, because what lies behind it is pain. The pain that comes when you realize that you acted on a whim and the anguish you feel when you have to square up your position because you cannot foot the margin. The gate to Heaven is far more unattractive- it is Grey in colour, places a premium on discipline and diligence and promises no short cuts. It promises happiness but does not promise that there will be no pain along the way. Invariably this is where we falter. The correct use of the key in an attempt to open the gate leading to paradise does not mean that you will experience no pain. But that does not mean that you throw away the key or walk over to the gates to hell. But why should there be pain on the way to heaven? Simple - the higher rewards that the use of this key brings. It is the premium you earn for taking on additional risk, for deciding to accept and put up with pain (think volatility) in an attempt to make it to heaven. Our own portfolios have faced the heat of this meltdown with the Hammock losing 26.80% and the Hot Chocolate losing 43.15% since their launch in early April. But we believe we are using the key correctly. We reiterate these principles regularly in our School section. Because we want you to understand how to use the key as well. We face the pain just as you do. But the gate to paradise never promised that there would be no pain along the way. As long as we use the key rightly and focus on the correct door we will find our heaven.
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Soul-searching time
The stock market is governed by two forces - fear and greed. And it doesn't take much to figure out that fear is the dominant force these days. It's not a happy feeling that I experience when I pull out my portfolio every morning and calculate the damage. Afraid is what I feel. And with fear comes denial. I'd rather not look at my portfolio at all. For it hurts to even to look at it sometimes. But look you must. And you must ask yourself some hard questions too. How much of the damage is of my own doing?

Did I buy the wrong stocks (at wrong price)? Did I buy the right stocks (at right price)? Did I buy the right stocks (at wrong price)? Did I commit the mistake of not selling when the stock got dear?
The answers will determine your future course of action. Getting rid of the wrong stocks will give you the cash to buy the right stocks (which you bought at the wrong price) at a reduced price. As for the right stocks, even if these do trade at lower prices, there is no cause for worry. And what if you realise that you should have sold some stocks at higher prices when the opportunity presented itself earlier? Ah, that's a tricky one! The way to solve this problem is to ask yourself another question - If I did not hold this stock and had some ready cash, would I still buy the same stock? The answer to that question will tell you what to do. So, go ahead and ask yourself those tough questions. Running from your portfolio won't help!
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Back to basics
Investing in equities is akin to owning a business We all know this, right ? Yet, most investors I meet seem to have forgotten this basic fact. But I don't blame them. After all, 80% of the daily traded volumes at both exchanges is concentrated in 10 volatile stocks. And actual deliveries (transactions which are settled by delivering stock or money) amount to less than 25 % of traded volumes. Meanwhile, the investor is being inundated with news of how the FIIs did this and the Nasdaq did that. How the Big bull is ramping up xyz stock or that the No.1 Market-maker is holidaying in the Bahamas and that is the reason for inactivity in the market. Groggy from this overdose of news and rumours, it is easy to forget that Investing in equity is akin to owning a business. When you buy shares in a company, you are providing capital for the company, which is represented by an equity share. You are participating in the ownership of the company. Clearly the risks are high, because you are entrusting the company (the management) with the job of managing the business for you. Once you look at it this way, things fall into place. Figuring out which company to invest your money in is no different from the process you would adopt when getting into business yourself. How would you go about identifying which business you want to be in? For starters, it should display the potential to earn you a return in excess of what the prevailing rate of bank interest is, right? But that is not enough, is it? You would want the business to earn a return far higher than that for it to be worth your while. And you would want those returns to be consistent. After all who wants to run a business in which one year there is a pot of gold and the next a gaping hole. Consistency counts if the home fires are to be kept burning. The ideal business would thus be one where profits can be sustained over a long term. There are many external factors that will determine the direction and growth of the business. And you would like to be in a business where you understand these factors, bring certain key strength and skills that will help you face up to the challenges peculiar to the business and not have to deal with too many factors which are completely out of your control. Of course, on an ongoing basis, you would definitely want to evaluate the performance of your business. Operations would have to be evaluated from market feedback, while the financial statements would give a view of the profitability of the concern. The same concepts apply to stocks Now, here's the punch line. Everything we discussed above doesn't apply only to running a business. The same concepts apply, even if you just own shares in the company. The common question that pops up in this context is: "How do I externally control the business if I do not have a say in the management?". Ok, let's assume that you are now running the business you chose. Can you, a single individual, handle all functions of the company? For a while, maybe. But once growth sets in, it would be humanly impossible to manage all the functions of an economic activity, viz. marketing, finance, procurement, etc. That's when your business will need to morph from one-man outfit to organization status. Wherein the various functions are distributed across individuals, and finally the same is translated into a unified activity. Similarly, as a shareholder, you end up delegating authority to others to run the organisation you have a stake in. Imagine Mr Narayana Murthy (Infosys), Mr Manvinder Singh Banga (HLL)
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and Mr Anji Reddy (Dr Reddy's) reporting to you. That's exactly how the cookie crumbles. The company whose equity you have participated in is answerable. To you, as well as other shareholders of the company. Thus, while you as a joint owner have delegated the operations of the company to the professional managers and the employees, the management in turn is responsible to its shareholders. The management communicates through the balance sheet and the AGM, where shareholders voice their opinion on the performance of the company. Unfortunately, investors seem to forget this. I know a smart businessman from Jullundar who is very careful about who he does business with and doesn't like to take any credit risk. Yet, he doesn't think twice before investing his hard earned money in a company whose balance sheet is full of holes and whose payment track record leaves much to be desired. Why? Well their p/e is lower than that of the Industry leader. Hmmm. Or the honest school teacher from Ahmedabad who reads Dr Radhakrishnan by night and invests her savings in a company whose management, is, well, not quite straight. She bought into the company because her colleague's brother who happens to work with this large broker in Bombay tipped her off on what a certain FII is going to buy today. It was to be a quick buck. In and out before you know it. It has been 8 months since then. Chew on that, while I drum up some more investor anecdotes for you.
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Financial Resolutions for the New Year

On the stock markets, Y2K has been quite a roller coaster of a year. The wild ride up to the highs of February and then the plunge - that practically never stopped. I am reminded of the classic film - 'Never Ending Story.' (Maybe you should watch it? anything to get your mind off this bruising market
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In a strange way, the October - December patch of 2000 was quite reminiscent of the December 1999-February 2000 period. I am sure you remember that time. Every day the newspaper headlines were dominated by positive stories. Mr.Premji was getting richer everyday, Nasscom's projected figures for software exports from India were sounding rosier by the minute, Indians were making it really big in Silicon Valley and the Nasdaq was defying gravity. It was a time when making money was very easy. You just had to be there and buy something, anything. It turned into gold. It was unreal. Now it's the same. Except for one big difference. Everything you own is turning into clay. The good, the bad and the ugly are being treated with equal disdain. It does not matter if your company has reported a 50% jump in profits or a 300% jump. It does not matter if they exude confidence about the future. The newspaper headlines rule again - Dow cracks, Nasdaq falls, Industrial growth slows, S& P downgrades, Middle East crisis... The cup of woes is truly overflowing. Just as there was a lack of discerning judgment in the heydays, there is a similar lack of discerning judgment today. On the bright side, such times rarely last. And this too shall pass. What's more, trying times like these are a great opportunity for you to take stock of your investment strategy and portfolio philosophy. To ensure that you do not repeat the mistakes of the past, here are some principles that you would do well to remember and follow - through the good times and the bad times. You might even see them as your own list of 10 Commandments for Profitable Investing. Always think Portfolio Investing in the stock market is about owning a basket of stocks. It is not about owning just one hot stock. So always look at buying more than one. In that process you may end up with 5, 10 or even 50 stocks. In the course of my practice, I have come across people who own as many as 500 stocks in their portfolios! What's the right number? Hold on just a while longer and I'll get to that point. Diversification is the name of the game The objective of the Portfolio approach is to diversify risk. You might want to ask me at this point - does a portfolio consisting of only 10 (for the sake of argument) steel companies constitute a good portfolio (or 10 software companies for that matter)? The emphatic answer to such a question is, No. The portfolio approach calls for diversification. And you do not achieve that when you own a portfolio of just 10 steel (or software) companies. The factors that affect the steel (or software) business will take their toll on each of the steel (or software) companies in your portfolio. Even the market risk does not get spread out. Hence, this portfolio is as risky as the one with just one steel company. It fails because there is no diversification across various businesses. But remember that diversification is the means to an end (returns), it is not an end in itself. Focus, Focus, Focus? In the pursuit of the noble objective of diversification don't spread your net (portfolio) too wide; otherwise it will become unwieldy to manage. Also remember that there is a trade-off between
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risks and returns. As the number of stocks keeps increasing, not only does the portfolio become unmanageable, it begins to reduce your returns! In medical terms, too many pills can have undesirable side effects! As a rule, I would recommend that the number of stocks in a portfolio should never be more than 15. It is quite difficult to keep track of a large number of companies. Sure enough, just when you are not looking one of them will punch a deep hole in the portfolio. Also, do the arithmetic: if a stock accounts for just 1% of your portfolio and it doubles, your portfolio return goes up by just 1%. Hardly anything to get excited about! There's no such thing as a free lunch There is no such thing as low risk with high return. I hate to disappoint you, but that is the truth. There are no magic pills. You cannot "have your cake and eat it too". A portfolio is always a trade-off between risk and return. Building a Portfolio is all about balancing these two opposite forces. It is about optimising returns, given a risk profile and an investment horizon. Hence, it is important that you understand your risk profile before creating a portfolio. Seasonality never pays I know a lot of people who turned off the equity market during the period 1995-1999. After sitting out the best part of a 15-month rally that lasted up to Feb2000, they decided to jump in just at the wrong time. Look no further than Mutual fund collections in the first quarter of this calendar. They surged to levels not seen in the past 5 years. Just as you need to earn money every month to keep the home fires burning, you must save money on a regular basis. And importantly invest that money in equities on a regular basis. Most investors tend to fall victim to the volatility. Buying only when everybody is talking about the market and the headlines are unambiguously bullish. And selling out of equities when the bearish crescendo reaches a new high (or should I say low). Don't fall victim to the volatility that is part and parcel of the stock market. Instead use the volatility to your favour - invest consistently and steadily through all swings and seasons. Investing in equity is as much of a regular activity as brushing your teeth is. Get in for the long haul Investing is all about time in the market, not 'timing' the market. It is very difficult to accurately and consistently picks market bottoms and tops. In fact some would argue it is futile. The 'experts' will frequently fall flat when it comes to forecasting tops and bottoms (yours truly included) for the stock market. But the longer the time you spend in the market the less the impact that timing has on your returns. The smart investors are the ones who understand this and stay in the game for the long haul. The method of rupee cost averaging (wherein you invest a fixed amount of money at regular intervals) delivers returns that are comparable to those you will earn by catching tops and bottoms successfully over the long term. There is a wealth of data and studies to that effect and any decent financial website will tell you more about the concept of Rupee Cost Averaging. Speculation? Not for everybody Never use margin money to buy stocks. You should not invest money you don't have. There is a logical process to our monetary life. First you must earn money, then save some and finally invest it. Just as it is not a good idea to spend everything you earn, it is not a good idea to invest money you don't have (by borrowing). That by the way is not investing - that is called speculation. Now, speculation can be extremely profitable but it can also be extremely harmful to your financial health. In fact, profitable speculation is a full-time job. So unless you have the requisite skill sets, and are willing to chuck your day job, don't even think about it. Here's a hot tip for you. (There is no such thing) There is no alternative to doing the hard work that must be done before making an investment. You must do your own due diligence to determine what is best for you. Do not accept advice from anybody and everybody. And be wary of the so-called hot tips and sure-fire tips. They might seem cheap but they eventually turn out to be pretty expensive. Equities means ownership Oh, how often we forget this! The difference between investing money in a business of your own and investing in equities in the stock market is? Zilch. That's right, there is absolutely no difference. Just as you would need to hire a bunch of managers to help you manage your business, when you own shares in a company you have outsourced the management function to the incumbent management of that company. Would you hire somebody you don't trust as a manager in your company? I can't see why you would. So why invest in a company whose management you can't trust? Would you invest in your business if it were not growing, if it were not earning you a return of at least 20-21% on the capital invested? Unlikely isn't it? Don't drop the bar when you screen the stock market for companies to invest in. There are no tricks to investing The trick to being a successful investor is no trick at all. It is all about discipline. In fact successful investing is 99% discipline and 1% everything else. It not just about remembering the 9 principles that I just laid out, it is about having the discipline to stick by them, through thick and thin. May the New Year usher in prosperity and make you a wiser investor.
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Vision + Strategy
One of the eternal battles in the media business is over who calls the shots?the delivery medium or the content producer? For example in the Internet business, who will reign supreme?the ISP who provides you Net access or the content provider who provides the matter that makes you sign up for an access service? Is VSNL (access) or Rediff (content) or Sify (access+content!) going to be the winner of the Internet sweepstakes? But this is a debate older than the author and I have no claim to being able to resolve it satisfactorily. But it brings us to another question. What do you need to make money in the stock market?the ability to pick winning ideas or the right investment strategy (the science behind your buying, selling decisions and portfolio allocation, management decisions)? Edison?s famous words?"Genius is 99% perspiration, 1% inspiration"?seem to suggest that strategy and implementation are more important than the throwa-dart, one-in-a-million stock pick. Our own homegrown achiever, Azim Premji of Wipro, made a thought-provoking statement along similar lines while accepting the Businessman of the Year award. He said, "Ships are safe in the harbour. But that is not what they are designed for. A vision cannot be safe, strategies must de-risk it." If you want to enter the stock market, you must be prepared to leave the harbour. And once you have set sail with your vision of making a strong and loss-resistant portfolio with your stock picking skills, you will need your strategy and its implementation to give it direction. Strategy issues loom large. You could choose to be a trader with a buy-anddispose philosophy or an investor with a buy-and-hold approach?and succeed in either role. Implementation of strategy is the key to success. As a trader, you need to align your actions?follow stop losses and don?t overtrade. As an investor, you need to be tenacious?stand by your decisions in the face of many bear hugs to come. I don?t mean to preach, merely highlight this fact: A strategy is as important to a project as the vision that drives it. Don?t take it from me?ask the wealthiest man in India, Mr Premji.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page I do not have a green thumb and I make no bones about it. The efforts involved in raising a plant are way too onerous. I don't mind the trip to the nursery and I don't mind the time involved in choosing the plants I'd like to see grow in my balcony. What I hate or rather hate myself for, is my inability to remember to water the plants everyday. Investor Memoirs Getting Started - How to Begin Investing Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
No green thumb
What I really need
I do give it a shot every now and then but invariably the demands made by the plant's constant need for nurturing by way of water and nutrients is beyond my ability to provide. What I have always hoped for is that the biotech revolution will soon pave the way for a sapling that does not need water to grow. If science has made possible a wrinkle free shirt and pre-faded jeans then why not plants that do not require daily watering? If you want to introduce some jargon into the argument at this point-we could call such a plant a self-sustaining plant. One shot of water the day I bring it home from the nursery and then no more water required. Wouldn't you pay a premium for such a plant? I for one sure would.
A self-sustaining plant
It's the same in the stock market
the right price.
Not surprisingly my willingness to pay a premium for such a selfsustaining plant finds echo in the stock market. After all the stock market is the ultimate market place in which a large number of smart people with differing notions of value constantly seek to find
Yes, that's right. Just think company instead of plant. And think equity (financing) instead of water. Companies that visit the stock market to raise funds less often always appear to trade at a premium, as compared to their brethren who visit the market oh so frequently to raise money. And returns earned by owning shares of such companies typically beats that earned from others. Of course there is more to the premium that one company enjoys over another in the stock market than just its appetite for money but the correlation is sufficiently high enough to suggest that this is an important criterion. In fact the premium that most MNC companies have enjoyed as a group is in large part attributable to their non- recourse to equity funding. It is a different story that in recent years due to their (minority) shareholder unfriendly policies that premium has vastly eroded. Reliance Industries makes for a fascinating case study of the linkage between returns and self-sustaining growth. Reliance and the capital market cult in India are so closely entwined that it is difficult to separate the history of one from the other. As the most widely held stock in India the company has done much in terms of furthering the equity cult in India and perhaps this very effort is in turn responsible for their own success. The company by its own admission tapped the market innumerable times for raising equity between 1978 when it listed and the early 1990s. Its last equity issue was in 1994, a good 7 years ago. But in the intervening period its equity ballooned as a result of a constant spate of rights issues, mergers and overseas issues. Its equity capital ballooned from Rs51cr in FY1985 to Rs462cr in FY1997. It has since risen further to Rs1053cr as a result of a bonus issue and Warrant conversion.
A premium
Reliance-a thirsty company
What of the investor?
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And how does an investor in Reliance fare as a result? Well over the last 23 years since Reliance went public-not too badly at all. An investors who invested Rs1,000 (100 sharesxRs10) in the company in 1978 and did not participate in any further issues now holds 512 shares in the company valued in all at Rs1,92,000 (@Rs375) ignoring dividends-an annualized return of 26% pa. A creditable performance that would warm the cockles of a Reliance shareholder and make envious those who do not own it.
Sharp variation
What I however find more interesting is the sharp variation in the returns earned by the shareholders in the dilutive era that prevailed up to FY1995 and the post dilutive era ever since. Reliance's last dilution was an equity issue in 1994, which is recorded in their FY1995 balance sheet. All increases thereafter being due to conversion of previously issued instruments (convertible bonds/warrants). These were outstanding as of the FY1995 balance sheet. (Trivia-Reliance's last issue in 1994, was a private placement of equity with UTI and other domestic financial institutions, a deal which raked up quite a muck in the press and even in the Parliament)
Let's split the return that a shareholder earned during the entire period 1978-2001 into 2 parts. The first part being the return between 1978 and March 1995, marking the balance sheet of the last year in which they diluted equity capital and the second part being the return earned thereafter. For the purpose of this analysis and for the sake of simplicity I am presuming that this shareholder did not participate in any further offerings by Reliance during the period 1978-2001. Of course he would receive any Bonus shares issued during the period. The person who bought 100 shares of Reliance with an outlay of Rs1000 in 1978 was the proud owner of 256 shares of Reliance in 1995. In March 1995 Reliance closed at Rs130 and hence the value of the holding amounts to Rs33,280, a compounded return of 23% pa. Good, but note that this return for a 17-year period is lower than the return over the entire 23 year period in spite of accounting for over 2/3 of the period in terms of time.
Splitting the returns
No more issues
Now if some of you are as ancient as I am you will remember that after the controversy surrounding its equity issue in 1994 Reliance more or less promised that it did not intend to dilute equity in the future. The company has come good on that promise. It has been 7 years since its last issue-quite remarkable for a company that saw its equity balloon nearly 10x in the 10 year period between 1985-1995 through constant dilution. If you had been wise enough (unlike yours truly) and taken the company's word, bought shares in Reliance in March 1995 then you would be laughing all your way to the bank.
An investment of Rs13,000 in 100 shares of Reliance in March 1995 would be worth Rs75,000 today a compounded return of nearly 34% pa in the last 6 years. In other words the returns earned by buying Reliance in 1995 after it became a self-sustaining company (plant) that required no further equity funding (watering) are nearly 50% higher than the returns earned in the previous 17 years.
Returns get better
Need I say more?
Do you need any more proof that buying self-sustaining companies is far more rewarding than buying companies that need constant daily doses of water and nurturing? In fact the returns of 23% pa in the dilutive era that prevailed up to 1995 are overstated to the extent that in this analysis I have ignored the various rights issues done by the company. These had a depressive effect on returns because the Reliance share price stayed in fairly wide range during its dilution prone years. You could have sold your 256 shares at Rs130 way back in 1986 if you had chosen to and the incremental investment in Reliance during that period really started to earn positive returns only after 1997.
Buy those who don't need it!
Biotech might not have come so far so as to produce plants that require only one single dose of water (did somebody say cactus?) but in the stock market there are companies that can grow without cash and those that need cash. In a perverse way it is the companies that don't need your cash that are likely to be more rewarding!
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Time to take a break from the classroom. Time to share some experiences and have some fun. Investing in stocks is a serious game, know your rules before you break it. Chapter 1: Market Memoirs Chapter 3 Chapter 2: Investor Memoirs Chapter 4: Market Lore
Pro analysts share their secrets and more here...
Chapter 3: Analyst Memoirs

Article 1: Fear of falling | Jun 18 2002 Find out how a professional learnt his first lessons in investing way back in time... Article 2: Want to buy a stock, talk to your wife | Jan 1 2000 A pro analyst shares his secrets on 'common sense' investing... Article 3: This too will pass | Oct 13 2000 In a strange way the current depressed market reminds me of February, earlier this year... Article 4: Of course I am scared | Apr 22 2002 Are you thinking of taking sanyas from the stock market? Change your plans, dear investor. Article 5: Why read newspapers? | Apr 8 2002 News headlines can conceal more than they reveal. The devil is always in the details.
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Article 6: Of unintended consequences | Apr 26 2002 As an investor you need to insure yourself against unintended consequences. What are these? Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Turn the clock back to 1994. I am just 24 years old. And my career graph is already looking up. I am recognised as a hotshot research analyst. One day, I am asked to work on two large companies from two diverse sectors - MTNL and SBI. 'Wow!' I enthuse. 'What great companies! Natural monopolies, these. How can anyone ever compete (even if the government allowed them to) with these lovely companies? MTNL has India's two richest cities wired on to its phone network, Bombay and Delhi; and SBI has distribution even where HLL soaps may not be available - it has branches everywhere.' Which is when one of my client butts in, 'Which bank do you have your personal savings account with? And are you happy with your home phone?" 'Uh,' I mutter. 'It doesn't matter. It doesn't matter because, dear ma'am, we are discussing monopolies here, monopolies with a capital 'M' you see. They are like the classical tollgates. Wanna enter the city? Pay up.' 'I still want my answer,' the client insists. Some hmmmm, wellll, aaawwww later, I surrender. 'I bank with Citibank (read because I hate to wait at SBI counters and dislike being treated like a convict at a police station). And I would prefer if my phone line would develop faults less often, and when faulty, would get fixed without me having to wait a week.' 'But you see,' I add, 'customers always crib. And how does it matter, they are monopolies!' Flashback over. Let us come back to the present. Circa April 2000. SBI is at Rs203 and MTNL at Rs223. Guess what the prices of these stocks were six years back? MTNL was ruling at Rs225 while SBI was at Rs240. Six long years have passed, and lot of earnings growth taken place. But their prices are where these were?ugh! HDFC Bank came into the world in May 1995 at Rs10, and is Rs230 today. Flashback time again (I love movies you see). This time round, turn the clock back to 1974. I am a kid of five learning to ride a bicycle. One day, I fall off the cycle and hurt myself in the process. And for days I avoid my bike like the plague. My father cannot stand it any longer. He puts me up on a chair and drills into me, "It is important to experience the fear of falling. Only then will you learn not to repeat mistakes." Do monopolies have this fear of falling? They know damn well that customers do not have a choice. They are the tollgates remember. How does it matter if the customers are unhappy? But the truth is: it matters. Maybe it does not, over the short term. But over a longer term, it does. Someone out there can see that you are goofing up, that your customers are unhappy. And he will move in to take your lunch away. Maybe by inventing new ways of doing business (ATMs, Internet) or by using new technologies (mobiles, VOIP) etc. Dethrone you, he will. And the market is smart. Somehow it can see over a longer term. And much before this new thing comes in to punish a monopoly the market gives its verdict. Fear of falling and the will to stand up and run again is important. And all of us learnt this lesson when we learnt to walk for the first time. Analyst Memoirs Getting Started - How to Begin Investing Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
Fear of falling
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Analyst Memoirs Getting Started - How to Begin Investing Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
Want to buy a stock, talk to your wife

First let me introduce myself. I am an equity analyst. Been one for the last seven years. And I have not done too bad, if I may say so. I have been able to outperform the Sensex for all these seven years, starting 1993. Well, I had enough reasons to believe that I was the real hotshot stock picker on the street?until of course I discussed stocks with my wife. Enlightenment happened one fine day, three years back. In August 1997 to be precise. She has heard me often on StarTV Business News. So, that particular day, she asked me to explain the meaning of those fancy jargons that I employ to describe the market's shenanigans. I thought I would impress her (some more) with my knowledge. After some trouble trying to explain EPS and PE, I decided to enlighten her about how I had beaten the fixed deposit returns and made money for our family, by investing wisely in equities. I also informed her of my investments in Bausch & Lomb. Boasted how I had bought the stock at Rs100, and how we would make oodles of money as contact lenses and Rayban sunglasses are growing businesses. 'Well,' she said, 'Novartis makes better contacts.' Apparently, she had bought their CIBA vision contacts only a week back. 'Look, I don't understand your language, but you should sell Bausch & Lomb and buy Novartis,' she recommended. 'Ha,' I said, 'go back to teaching kids (she teaches 'thinking' skills to school kids).' Want to know what happened to Bausch & Lomb and Novartis? Over the next 12 months B&L crashed 50% while Novartis doubled.
The million the I missed
Around the same time, trying to recover from this humiliation, and to prove that it was just a fluke, I asked my wife to recommend another stock just to see if her first pick was not a fluke. She asked me to buy Henkel Spic. Why? She had just replaced 'Ariel' with 'Henko' as her washing machine detergent. She said that it gave her the same results at half the price. 'No way,' I said. 'It is a loss making company. And will never make profits.' No, no, don't even try to hazard a guess - the stock was Rs16 then?and I have lost a three-bagger till date because I refused to act on my wife's advice. Well, at least I can take pride in saying that I am not stubborn or incorrigible. For few months later (after Henkel had already risen 100%), when she told me that our one year old son consumed only 'Britannia' cheese (and actually rejected 'Amul'), I bought some Britannia stock?and I am up 100% over 26 months. Now, my better half even has her own top picks. Her three best buys are: first, HLL - she says that you just can't get away from HLL. More than half our kitchen, bathroom and dressing table items come from the HLL stable. Secondly, Zee TV - no, she does not watch TV much. But she does crib that the few hours, which I do spend at home, are all gone watching Zee! And last, Infosys - she does not understand tech. She had watched Narayan Murthy's interview once; she is convinced that the man is sincere, visionary and yet down to earth - recipe for success, according to her. Takers, anybody?
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This too will pass

It's been a horrific week And that's putting it mildly. Wouldn't you give a hand as well as a leg just so that you are able to go to sleep and wake up a month later? Or maybe you would rather not. What if you wake up to find the market even lower? So while your eyes remain focused on the screen, beads of sweat continue to form on your brow and in the background, the only sound you continue to hear is that of your heart beating. What a year it's been! Remember the highs of January and February and the lows of May? And just when you thought it was safe to go out again -- Part II. It is almost like a conspiracy. All at the same time the Reserve Bank of India and CMIE and even Standard & Poor's wake up and downgrade their outlooks. Thank god for competition -- at least Moody's stood up for us! In a strange way all this reminds me of the period during December-February, earlier this year. I am sure you remember that time. Every day positive stories would dominate newspaper headlines. Mr Premji was getting richer and Nasscom's projected figures for software exports from India were doing the rounds of the market. Indians were making it big in Silicon Valley and the Nasdaq was defying gravity. Money-making was your birthright. Everything you touched turned into gold. It was so real that it was unreal. It's unreal again. Only this time it's painful. The crash into the lows of May had brought you back to earth. The mistakes brought about by a bull market were all too apparent. Salvation could be had if you cleaned your cupboard and stuck to the high ground. With a portfolio of sound companies you could make it out of the trough. But the trough is beginning to resemble a deep hole in the ground and the way out is not clear. Even the healthy are falling by the wayside. What do you do when a company reports a 135% growth in profits, beats analyst estimates by 9% in the process and yet slips 15% in the end? Sure the company (Infosys) is not cheap -- it trades at a price earnings ratio of 75x on FY2001 earnings. But how can you ignore the fact the company is expected to grow at 75-85% next year. The company is now trading at a price earnings to growth ratio (P/G) of just 1 based on FY2002 earnings. That is cheap. That is attractive. Period. And that's what makes the current situation unreal. The market is refusing to discern between good and bad anymore. Just like it was refusing to do so eight months ago. The feel-good and the bullish headlines of earlier times have been replaced by an all-pervading depression and stories about earnings warnings, falling global markets and poor economic outlook. And now the Middle East crisis. It's the same story. Only it's playing the other way round. The good news is being ignored. But the market cannot stay detached from reality for long. The market cannot ignore the good for long. This too will pass.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page When I said that to my closest 'stock-market' confidante, he retorted that I would be inhuman not to be so. That in this kind of a market if I did not worry or indulge in some soul-searching I would be abnormal. According to him I definitely need to ask myself if I am holding the right stocks, I am leveraged and whether I have enough cash in my bank account to pay for the holiday that I am planning to take next month. I believe I am holding the right stocks, I don't need cash tomorrow, and I am not leveraged. So, why the hell am I hurting so much? Switch on CNBC, and you hear about a global equity meltdown. Open the pink papers, and doomsday forecasts stare at your face. Resolve fiscal deficit crisis tomorrow, or India is dead. Privatise PSUs next month, or else you will find yourself in a debt crisis. Economy is slipping back into recession. World's leading rating agency S&P has downgraded India. Oh my god! Should I be shifting all my savings to fixed deposits? But are fixed deposits safe? With this kind of an economic crisis, won't the banks go bankrupt? Maybe my grandfather was right -- capital is safe only in gold and cash should be stashed under the mattress. Wait a minute! I think I have heard this before. At least four times in the last six years that I have spent investing in equities. And always around Diwali or towards the end of the year. In 1995, 1996, 1997 and 1998 to be precise. And each and every time I felt like going back to my father's farms and breathe the fresh village air. I thought the equity market was for gamblers. That India will remain a loser. Every time I had those dark thoughts the market would bounce back by at least 1500 points, or 6070%, from the panic levels. Imagine if I had given in to my deepest fears, swayed by market sentiments, I would have missed out on the market bouncebacks. Moral of the story: don't just follow the herd, look for what the herd is doing. To fight a movement is foolish. But when a movement becomes herd behaviour, jump. In market parlance, buy the rumour and sell the news. When newspapers and magazines (and rating companies?) forecast doomsday, they actually mean that bad days are coming to an end. When you feel like boarding the next train to your village, check the booking positions. If you 'spot' the herd on the train, stay back. Just a while! Works the other way round too. Keep a watch on whether your driver is asking for stock-tips. Or everybody on the local train is pouring over stock quotes. Or your old father-in-law, who knew no better way of protecting capital than by stashing cash in the pillows or buying jewelry for his daughter (my wife most of his money in stocks. Analyst Memoirs Getting Started - How to Begin Investing Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
Of course I am scared
J), begins to put
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Two pens, two colours It was the start of what was looking to be a depressing day. The Nasdaq composite was down 7% and the market looked set to open sharply lower. But the daily routine calls for a research-sales morning meeting and we got down to business. On my way in to work I read the Times of India, in which there was an article suggesting that Nicholas Piramal was the frontrunner in the race to acquire Rhone Poulenc. Now Nicholas Piramal is one of our Apple Green stocks and when a company does a large acquisition, it is only natural that one take a hard relook at the company. So the meeting kicked off on that note: What happens to Nicholas Piramal if its bid to take over Rhone Poulenc is successful on the terms being bandied about by the newspaper? No sooner was the topic tabled, a voice popped up: "Don't you mean what happens to Wockhardt if they take over Rhone Poulenc?" "No, I mean Nicholas Piramal," Yours Truly assured the Voice. And then somebody thrust the Business Standard, which I had not read, in front of my face. It screamed 'Wockhardt, frontrunner in race to acquire Rhone'. Uh oh! Two different news papers, two different stories. Moral of the story? Read all the newspapers you can. Discount the grapevine But seriously. This is the information age. And sometimes, there is more information going around than we need. Some of that information is based on facts, a lot of it is analysis but some is rumours, whispers and what have you. As an investor, you need to exercise care when acting on this information. Acting on rumours, whispers and information that comes from "sources" can be injurious to investing health, to say the least. Rumours are all too often just that - rumours. Some of them may turn out to be true, but equally often (maybe more often) they will not. It is up to you to exercise discretion. The devil is in the details But deciding not to act on rumours and hearsay is the easy part. Unfortunately, even in the case of factually correct information, the way facts are presented can lead to incorrect and misleading conclusions. Delving beyond the headlines becomes very important because of headlines such as these: 'Bhel Q2 net falls 90.69%' - The Economic Times, 2nd November 2000 'BHEL net profit at Rs11.90cr' - Business Line, 2nd November 2000 The second headline is quite innocuous - so much so that you might choose to gloss over it. But the first one is quite an attention grabber and packs quite a punch, doesn't it? And it does make a world of difference, depending on which one you read. Hence it is very necessary that you delve beyond the headlines to reach your own conclusion and verify the source before you act on it. The Wipro ADS: from different perspectives Here's another example. These are the headlines that appeared in the business dailies the day after the Wipro ADR was priced: 'Wipro ADS priced at 14% discount to BSE closing' - Business Standard 'Wipro makes NYSE debut at a premium' - Business Line 'Wipro ADS opens at $44.5 on Wall Street' - Financial Express Analyst Memoirs Getting Started - How to Begin Investing Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
Why read newspapers?
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'Wipro ADS priced at $41.38, lists at $44.5' - The Economic Times It makes a world of difference which one you read. The only headline which told you the most materially important point was arguably the first one. And you could have carried away a different picture about the success of the Wipro ADS based on which headline you saw. To be fair, though, reading the entire story (in all the cases) would have presented the most meaningful fact - that the ADS was in fact placed at a discount. Was that the same story? Of course, facts can be presented with very different implications and analyses as well. Consider this set of headlines from two different newspapers for the same story. 'Foreign investors invited to help store grain' - The Economic Times 'Govt to export grains at a loss' - Business Standard Don't get me wrong. I'm not trying to critique the newspapers. It's very likely that if you compare the headlines of the newspapers as well as many websites about the same event you might reach the same conclusion - headlines can be misleading. The devil is in the details. Not a unique Indian phenomenon, thankfully This is not even a situation unique to India. Check out this series of headlines about Coke's announcements made on the 20th of December in US papers. This was basically an announcement by Coke that volume growth would be lower than earlier estimates, although earnings would be as expected. 'Coke: Volume Will Make Small Gains' - AP Financial - 6:08pm 'Coke Sees Volume Growth Below Forecasts' - Reuter Business News - 4:44pm 'Coke Warns of Weaker Volume Growth, Reinstates Share Repurchase Program' - The Wall Street Journal Online - 1:50pm 'Coke Sees Q4 Volume Growth Below Some Forecasts' - Reuter Securities - 9:45am 'Coca Cola Comfortable With 2000, 2001 Growth Expectations' - at TheStreet.com - 8:57am 'Coke Sees Volume Growing 3 Percent' - Reuter Business News - 8:02am Imagine if you had just read the headline of this article! That is why it is necessary that one does not go by just headlines. And certainly not the headlines of just one source. There is no substitute to reading the entire analysis and perhaps doing some analysis of your own. Remember: you are the best guardian of your own interests.
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Of unintended consequences
The permanent contribution of a thing--movement, event, or meeting--is seldom the intended effect, but an unintended one. What we are emphasising here is that the announced purpose of a thing is seldom its ultimate contribution to history. As analysts, we are trained to focus on the consequences of every action taken by a company or any action taken by an external agent (such as the government) on the company that we track. Unfortunately, this methodology does not recognize the law of unintended consequences. So, this misunderstood law and oft forgotten postulation causes us much misery ever so often. Let's start with an example The law of unintended consequences manifests itself in many ways. Take the power sector for example. Would you believe that one reason for declining water table level in Gujarat is the provision of free electricity to farmers. What? Well, here is the story as heard from a former chairman of the Gujarat electricity board. The Gujarat SEB, like many others in the country, is in the habit of providing free power to farmers. However, as a result of such generosity (and power theft), the SEB is not in good financial shape. As a result, its plants run erratically and power supply is erratic to say the least, particularly in rural areas. Consequently, while the farmers are entitled to free power they are not sure when they would actually receive the power. SO, they choose to leave their pumps on all the time, so that whenever the power does come water would be pumped into the field irrespective of whether they are awake, asleep or not around. As a result of this, not only do the pumps run for much longer than actually required, but they pump out more water than required by the farmer. This, as the chairman revealed, resulted in a sharp drop in the water table level in several parts of the state. Not convinced yet? Fine, you may ask, but what relevance does this have to the world of investing? A lot actually, because an unrelated event or change might have an impact that you do not foresee. Another classic example of this could be Viagra. Did you know that the Viagra is a kind of lucky accident? Well, its application to impotence was discovered in 1992 while conducting research on heart medications? Pfizer did not go looking for this blockbuster drug, it just happened to notice that the drug had a side effect, which was in effect a cure that many were looking for. A macro example would convince you better Let us take another hot topic of discussion-the US economy. Alan Greenspan is cutting rates vigorously in order to revive the US economy. The economy has been driven by large investments in the tech sector in recent years. But this cutting of rates could have an unintended consequence and to quote from Marc Faber, author of the publisher of the Gloom Boom & Doom Report Investment booms driven by technological breakthroughs are deflationary. Railroads cut longdistance transportation costs. The tractor led to huge productivity gains and falling agricultural prices. The Internet has made voice communication almost free. The longer they last and the more capacity they bring, the more these capital spending booms reinforce the deflationary environment. The problem is not insufficient demand but overinvestment, which depresses prices and leads to disappointing profits. The solution is a painful but necessary and healthy (and, it is to be hoped, brief) liquidation of excessive capital projects. But Greenspan's aggressive rate-cutting will only allow weaker players to complete their projects and so prolong the capital-spending boom. The day of reckoning may be delayed, but it cannot be put off indefinitely. Regardless of central bankers' monetary policies, every capital-spending boom is followed, sooner or later, by massive corporate profit deflation and a very painful deflationary recession.
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Whew, In other words the cutting of rates might only delay the inevitable and worse still it might make the eventual consequences even more painful. Inference that you can draw Unintended consequences manifest themselves in more ways that we realize. The very fact that they are unintended consequences means that attempting to identify them in advance is a futile effort. After all, how can you predict what is an unintended consequence? Could you have predicted that Viagra would be the outcome of Pfizer's research effort? As an investor, therefore what this means is that you need to insure yourself against unintended consequences. This is not an insurance policy in the real sense but rather some steps and thought processes that can help prepare you for dealing with unintended consequences.
Spend as much time thinking about what can go wrong The focus of any buying decision is on everything that can go right for the company and for your purchase. But spend an equal amount of time thinking about what can go wrong and pick holes in your own positive arguments. Even though this might not help you identify the unexpected consequences, you might still be able to pick up on the early signs if you have already thought about it.
A stock is a sell until proven otherwise A friend of mine, and a good analyst to boot, once said that the secret of his success was that he treated every stock as a sell until proven otherwise. This is even one step better than spending as much time thinking about what can go wrong.
Beware of the consensus This is another rule of thumb that works quite well. More often than not the consensus view is not the right one. And questioning the consensus view can typically help you identify the not so evident risks.
Revisit your arguments frequently One way to reduce the downside from unexpected consequences is to revisit your argument for staying invested in the stock on an ongoing basis. This is a very difficult rule to implement. One of two errors can always occur-either one could sell the stock for the wrong reasons or alternatively one could stay invested for longer than required before admitting the mistake. Phil Fisher, the legendary investor and author of the must read investment classic-Common stocks, Uncommon profits once commented that you need to wait three years after buying a stock to reach a meaningful conclusion on whether you have committed a mistake. The significance of this statement is not that you have to give a stock three years to figure out if you have made a mistake. It is merely that if you are to arrive at a sound decision as to whether you have committed a mistake, you need to watch three years of performance. There is no magic formula here, but one simple way to solve this problem is to evaluate your purchases based on the time period you had in mind and the returns you were looking at. For eg, if you expect a stock to double in two years and it has not gone anywhere after one year of your holding it, you need to review your decision. Or if you buy a stock to make just 30% out of it in 6 months and it loses 15% in 2months you must question whether given your risk return framework it makes sense to stay invested.
Margin of safety The value investors' focus on margin of safety is perhaps the best possible insurance against the law of unintended consequences.
'What the value investors are looking for is margin of safety. They are looking at buying a stock at as much of a discount to intrinsic value as possible. This provides them with a margin of safety because the future is always difficult to predict!' The margin of safety provides the value investor with some protection against a negative surprise he did not foresee and gives him a twice the advantage when a positive surprise comes his way. The better part of the story With all this talk about unintended consequences you might jump to the conclusion that such consequences are always bad. Not necessarily, remember the Viagra example?
In fact, the most striking manifestation of the law of unintended consequences is our software industry. The unintended consequence of the Y2K bug was that it gave this industry a boost nobody could have predicted. If not for the Y2k bug would our software companies have managed to get their foot in the door? Hmmm?
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Time to take a break from the classroom. Time to share some experiences and have some fun. Investing in stocks is a serious game, know your rules before you break it. Chapter 1: Market Memoirs Chapter 4 Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
Investment wisdom in a capsule... Article 1: The 10 commandments of successful investing | Aug 31 2000 Coming down the stairs of the BSE building this is what Moses found on the 10th floor landing. Article 2: The 5 Steps to Investdom | Sep 20 2000 They say the stock market makes fool of everyone. Well, we have different ideas... Article 3: Five soulsearchers before selling a stock | Oct 9 2000 What's easier - buying a new shirt or disposing of your old one? Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
Chapter 4: Market Lore
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Market Lore Getting Started - How to Begin Investing Chapter 1: Market Memoirs Chapter 4: Market Lore Chapter 2: Investor Memoirs Chapter 3: Analyst Memoirs
The 10 commandments of successful investing

Moses was coming down the stairs of the Bombay Stock Exchange building after a rough trading session one rainy day and look what he found peeking out of the false ceiling on the 10th floor landing, written in the hand of God...
God entrusted to Moses the noble task of protecting the small investor from the vagaries of the market and the attempts of various vested interests to waylay them on their path to safe investing. Safe investing, said God, was a mere matter of following these ten simple rules. Commandment 1: Don't attempt timing the market Market timing is no guessing matter. To the little investor, timing the market is like taking a random walk. Most people only recognise the correct path after already having set foot on the wrong one. One exception to this is 'bottom-fishing', an approach to buying stocks that you want in your portfolio at prices below prevailing levels. This entails biding your time and buying into a market downturn before others do (the age-old philosophy of buy low, sell high), the downside of this approach being that the stock you want may never see the downside you expect. Commandment 2: Don't try to outguess the market Market psychology is for shrinks, not for couch potatoes like you humans are. What captures the imagination of the market is transient, which means that what is `in' today is `out' tomorrow. Most people only recognise the pattern after it has become apparent to almost everyone else and is too late to act upon. For example, if investment in technology appears to be the current flavour, you are probably already too late to cash in on the trend. In this instance, you should only invest in technology as part of a long-term balanced approach. Commandment 3: Treat investing like marriage - go for the long haul Short term investing could go either way. Invest long term. Almost all market pundits and investment studies show that stock investing should be part of a long-term strategy, lasting 5-10, even 20 years, or longer. Beware that not every year will result in a positive return on your investment. However, over time, the plus will likely overwhelm the minus by a substantial margin. Commandment 4: Stay clear of broker's advice, hot tips and "multibaggers" Every portfolio advisor is not a Sharekhan (J) who swears by sound investment principles. Think. Wouldn't most brokers be tempted to make their living by goading their clients to constantly move in and out of positions, thus garnering commissions? This is diametrically opposed to Commandments 1, 2 and 3. For most people, stock advice is like a game - of darts! Only accept advice if the person has your financial interest in mind - truly, that is - and is not making a living by selling your stock. And of course never buy from someone who calls you
J.
Commandment 5: Almost always invest in blue chips and blue chips-to-be Do invest in companies considered to be `blue chips'. These not only include the BSE 100, but others that are slowly stepping into the big league as well. Only invest in established companies with good track records. Beware that not every blue chip will increase after you buy it, and that even these otherwise stellar performers will have their good months/years and bad months/years. But, over time, the fluctuations will even out and you should be left with a considerable net plus. Also invest in companies which have a good record of declaring dividends (and if you find the solitary one that increases dividends each year...you know what to do). Commandment 6: Prefer steady instalment-like buying of stock to buying in one go Investing should never be done in a panic or treated as an emergency. Purchasing your favourite few is best accomplished at a steady rate over a period of time, so as to avoid the ups and downs of the market. This is called rupee cost averaging and is one of the safest approaches to investing. It works just like any other habit - you buy, regardless whether the price is up or down, until you reach the desired number of shares of that stock. Commandment 7: Diversify, diversify and diversify Do diversify your portfolio, both within your selected sectors and within overall industry. For example, don't invest only in technology because it happens to be in vogue today, but consider other industries as well.
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Commandment 8: No shopping with borrowed money and maintain a core reserve Never use margin money to buy stocks. You should not invest money you don't have. A simple and basic rule is to not leverage yourself to an extent that when the tide turns against you, all you are left with is nothing. You never know when a financial emergency might arise. That's why you must keep a comfortable cash reserve in your savings account, so you do not have to tap into your long-term investments. A reserve equal to 6 months of salary should be just about ideal. Commandment 9: Set realistic financial goals Treat a 500% return with as much derision as you would a 5% return. Decide what you need the money for - to retire early, to finance your kid's college education or your daughter's marriage? Or just in order to preserve and build wealth? Whatever the goal you set, make sure it is reasonable and attainable. Expecting too much will only lead to disappointment down the road. Aim for an expected return level that is realistic not mediocre or overambitious. Commandment 10: There are 10 more commandments! For those who thought that was the last of that, I have good news. There's more where that came from! Ensure that your portfolio size is controllable (15 stocks is about ideal), and your stocks are well researched. Checkpoints: Is the management quality above board? Does the company have a positive cash flow? Does it have the capability to compete on a global scale? Most importantly, is it shareholder friendly? Finally, leave your emotions behind when you enter the world of investing. Follow the ten commandments. Time is on your side. Investment success won't happen overnight, so stay focused on long-term returns and avoid overreacting to short-term market swings. Remember, investment success depends on time, not timing>.
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The 5 Steps to Investdom

To share or not to share "The main purpose of the stock market is to make fools of as many men as possible" - Bernard Baruch Oh? And we thought people flocked to the stock market because they believe they are wiser than the next guy and would naturally bag the bigger, better deal. Fear not, for we believe Mr Bernard was not really referring to the well aware investor in the market who abides by its investing credo. We say the main purpose of the stock market is to help enrich those who consistently save and invest, who have a 'buy and hold' philosophy. Our paramount advice to the retail investor: Dispel forever and ever the notion that you can correctly predict the daily swings of the market. Why invest? Which brings us to the next question - in that case, why invest? To fulfil certain needs or desires. You may have certain personal goals, ranging from, say, an early retirement, marriage, and kids' education to more specific material stuff such as a swankier car, a bungalow, and what have you... You may invest in order to make above normal returns, or maybe just to keep up with inflation, which presents itself at every turn like an unwanted ingrown toenail. Raring to go, but proceed with caution You're probably itching to take the plunge and start investing right now. But hold on - we don't generally eat dessert before dinner do we? So how can we invest before learning how to? Investing can be relatively painless, and the rewards plentiful. Investing successfully in the stock market could buy you your retirement, overseas education, dream holiday or simply enhance your status in the family to Most Cherished Relative. The following five rules and a prayer on your lips should take you there. Steps to Take Before Investing 1. Invest your own money -- credit cards are strict no-no The stock market and the world of investing are all about making more money than you would elsewhere. But before you get initiated into this system, make sure you aren't hitching a heavy debt-laden cart on the investing pony. Huge credit card bills, loan instalments, can be bad news when it comes to stock investing. And finally, don't invest on borrowed money. Playing the market on debt is something we won't be advising you to do. 2. Provide first for the necessities -- avoid putting that antique grandfather clock on sale God forbid, but in the rare occasion that you find yourself out of a job, you must comfortably land in the safety net of an ample corpus to protect you and the family from unexpected situations. You never know what tomorrow will bring. Unemployment, medical ailments, accidents, a housing need and other such contingencies should be accounted for. Set aside a liquid reserve fund that covers six months of living expenses and contingencies, failing which you run the risk of finding yourself at various auction sites on the web, trying to find buyers for that beloved antique grandfather clock. 3. Plan for the future -- an outstanding housing loan instalment is a taboo Understand your current spending pattern. The idea is to know exactly how much you can afford to invest in stocks. If you have a big housing loan to repay in the next three months, you cannot afford to stay fully invested in stocks with one-year horizon without planning for this payment. Else on the day of reckoning you will have to sell your stocks cheap!
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4. Identify your objectives -- can't buy oranges if you want to eat apples There is a general perception that apples and oranges taste different, look different and offer different nutrient values. The same holds true for different stocks. The most important groundwork in developing a portfolio is establishing and identifying your objectives. While everyone's needs and goals are different, it is important to sit down and know what you currently have, what you will need for day to day living expenses, and what future long-term strategic goals you want to achieve. 5. Invest time in market - save short-term funds for the family Caribbean cruise Invest money in the stock market that you won't need for at least three years, and preferably five years or longer. If you'll need your cash next year for a down payment on a house or for the family Caribbean cruise, use one of the shorter term and safer havens for your cash, such as money market funds or bank deposits. Sharekhan believes that these five points form the prologue to the investing novel. Let the above rules take centrestage in your head before taking that leap. If you can conjure up some more ground rules, post in your comments. We welcome an education too!
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Five soul-searchers before selling a stock

What's easier - buying a new shirt or disposing of your old one? What does a rising market do to you? You probably get complacent about your investments, just as you panic when the market takes a dive. Recently, when the BSE Sensex slipped some 900 points over 10 trading sessions, the natural reaction of a lot of investors was to get out. And get out... faaaaastt! But just as buying a stock is the end result, or should be, of an extended period of research, selling is also best done only after cool deliberation, not in the heat of crumbling markets. Do we hear murmurs of 'easier said than done'? After all, buying 'Annapurna' atta, a 'Gillette' shaving system, a pack of 'Nescafe' or the latest 'Color Plus' shirt we do every day, whereas most of us have much less experience selling these products. Believe us, even we - after years of prowling Dalal Street in a dark cloak - find it much easier to buy rather than sell stock. Because, while selling, we are beset by a host of questions. Do we sell winners in order to lock in our gains? Do we dump losers because they are, well, losers? Do we set price targets for each stock? Or do we follow Warren Buffet's investment style and treat stocks like marriages, never to be broken or betrayed? Making sense of stock price movements We carried out an off-the-cuff survey on what could be construed as dependable sell signs. Are there any in the first place? We came up with some very interesting feedback. One of the most obvious sell signals that's not dependable is a company's stock price - despite the attention we may lavish on its every move. Consider Hindustan Lever, which has fallen by nearly 35% over the past one year. You're thinking it's time to sell, right? Wrong. What good does it do to sell after the stock has fallen? Whatever the bad news, it's already incorporated in the stock price by now. The more rational reaction to a dropping stock price should be the exact opposite of selling. If we really like the company, we should take advantage of the lower price to buy more. In the case of Hindustan Lever, the stock has fallen because of a couple of quarters of top line underperformance, which we believe to be temporary. If we bought HLL because we liked the firm's long-term prospects and because the stock's valuation was attractive, a declining stock price over the short term should be little cause for concern. Likewise, just because a stock has risen is no reason to sell. It's always so easy to sell (or fail to buy) a great stock simply because it's already had a good run. Remember Infosys or Pfizer? You always thought you would buy those stocks on their way down, right? But an abundance of examples show that these stocks may never find 'their way down'. The fact is most of us would be better off if we could block out all those graphs of past stock performance. They convey no information we can profitably use now. So what are the points to ponder before selling your stock? Having established that past stock price performance is no reliable indicator for buying or selling a stock, here are what we agreed on to be a more dependable set of sell signals...better represented as questions an investor could ask himself. 1. Have the company's fundamentals changed? It's often tough to distinguish the normal fluctuations of a business from long-term shifts in fundamentals. If Infosys, because of a change in the foreign exchange rate (the rupee becoming stronger against the dollar), earns a little less than analysts' expectations, we wouldn't really care, since the company's long-term prospects remain unhurt. But if the changes are deep enough, the reasons why we bought the stock may no longer hold. We might own a Silverline Technologies because it was growing rapidly and valuations were attractive. But if then some news comes along on the company's accounting
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irregularities, we'd much rather be donning our warnings cap. 2. Have I made a mistake? Ever bought a pair of shoes that do not fit or a music cassette that was unspooled? These bad purchases could happen with stocks too. Just like one would reverse the above faulty decisions, you could do the same with your bad investment. Closely related to changing fundamentals are misunderstood fundamentals. Take the case of Real Value Appliances. At first glance, the vacuumiser that it introduced in the market appeared to fill the gap that a housewife had long waited for. With an attractive product and a virgin market to exploit, many were touting this company as a tempting buy. After a little research, however, it turned out that Real Value had problems maintaining product quality and hitting on the correct price chords. Result: the company lost money since the year of the launch of the vacuumiser. The stock has lost 90% of its market valuations since then. A real pity. The lesson here is: rather than hang on to a mistake in the hope that it stays above water, it makes sense to switch the money to a more compelling stock. 3. Can I sell if I have a 'better investment option'? When a business grows rapidly, the stock price will naturally trace the same pattern. But when valuations rise, the stock normally tends to outpace the business. Effectively, the price in the numerator of the P/E ratio will rise faster than the denominator, that is earnings. If we buy a stock not because we love the company, but because it is cheap, a rise in valuations means it's probably time to move on. Simple, isn't it? 4. Is it time to change the menu on my stock portfolio to make it more balanced? You love having idlis, but can you have them everyday? Prudence counsels spreading risks around, and that includes rebalancing a lopsided portfolio. Should we enter a recession, cyclical stocks are likely to do poorly. And should the bull market come to an end, portfolios concentrated in high-flying, expensive stocks (read technology) could be in trouble. For safety's sake, it pays to periodically check to see if a portfolio is diversified, with a good mix of sectors and maybe clusters too (take a peek at ShareKhan clusters) 5. Should I sell less attractive stocks to buy into the current fall in my favourite? What would you see if Infosys' price suddenly dropped down to Rs3,000 or Hindustan Lever's to Rs125? A great opportunity to buy some more of the same, of course! In such scenarios, where your dream stocks are going at basement sale prices, it may just make more sense to dump some of the less compelling parts of your portfolio to add more of the cheaper favourite stocks. After all, money is a scarce commodity. Money happy returns if you stick to a sell discipline... What's most important is not so much these five soul-searchers themselves as the thinking behind them: that selling stock by a set of pre-established rules surely beats offloading on a gut feeling or because of the current dull performance of a stock in a bad market. A sell discipline forces us to have a good reason for getting out of a stock - a reason based on important considerations such as company fundamentals and portfolio composition, not on "noise" such as fluctuations in prices. It is logical then that a sell discipline tends to reduce selling. When markets go through one of their periodic hiccups, it's the people with a sell discipline who refuse to panic, who don't sell after stocks have already tanked, which of course is the worst possible time to dump a stock. Plus, there are the nasty tax consequences of selling frequently. By making sure every sell decision is justified, we'll inevitably cut down on paying capital gains taxes. Knowing when not to sell may actually be the one of the best ways to improve long-term investment returns. And one which could lead to the fulfilment of your long-term dream of moving out from the ancient building to the latest high-rise at Napean Sea Road! Adios, amigos.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Advanced Investing
You know the basics. Now you are eager to know how to make money. Learn the tricks of being a smart investor. Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 1 Chapter 2: Understanding Chapter 3: Investment Markets Strategies Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Advanced Investing - Tips and Tricks
All about the various animals in the jungle they call the stock market, and what they all do Article 1: Kissa market ka | May 21 2002 You think there's little to differentiate the vegetable market from the stock market? Uh! Article 2: Speculation aint a fourletter word | Apr 4 2000 You heard it right. In the stock market everyone has a role to play, even the speculator... Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
Chapter 1: The Nature of the Market
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You know the basics. Now you are eager to know how to make money. Learn the tricks of being a smart investor. Chapter 2: Understanding Chapter 3: Investment Markets Strategies Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing
Chapter 1
All about the various animals in the jungle they call the stock market, and what they all do Article 1: Kissa market ka | May 21 2002 You think there's little to differentiate the vegetable market from the stock market? Uh! Article 2: Speculation aint a fourletter word | Apr 4 2000 You heard it right. In the stock market everyone has a role to play, even the speculator... Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
Chapter 1: The Nature of the Market
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You know the basics. Now you are eager to know how to make money. Learn the tricks of being a smart investor. Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options
Advanced Investing Tips and Tricks
Chapter 2: Understanding Chapter 3: Investment Markets Strategies Better
Chapter 5: Investing Styles
Chapter 6: Trader's Handbook
Chapter 8: Portfolio Strategies
Chapter 9: Essentials of stock picking
Chapter 10
Chapter 10: Psychology of Investing
Our mind our biggest enemy! Hard to believe? Discover the mind mines Article 1: Meet the 'Mind Traps' | Jul 17 2001 Cognitive illusions deceive the mind. While investing, avoiding these mind traps ... Article 2: Linear thinking | Jul 18 2001 Thinking along the straight line is not always the shortest path to the right answer! Our next ...
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Psychology of Investing Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Meet the 'Mind Traps'

Here is a quick test to determine your Investment Quotient (IQ). Stock A at Rs100 has a 7% chance of dropping below Rs100 in the next five years. Stock B at Rs200 has a 93% chance of gaining from this price level in the next five years. Which is a safer investment bet--Stock A or Stock B? In case you picked Stock A, you are being very smart or foolishly brave. In case you picked Stock B, you are one among the many investors who fall for a very common mental illusion caused by "Framing," according to behavioural scientists. In simple words, "Framing" stands for human fallibility to decide based on the way information is presented. Both the stocks have an equal chance of falling by 7% from their current levels. After all a 93% chance of Stock B going up means it has a 7% (100%-93%) chance of falling.
Let us revisit the IQ test
In case you chose Stock B, you are not very different from the average man on the street who prefers Stock B to Stock A just because it is presented in a manner that makes it appear more appealing. As humans, we always make approximations in our decision making process. No wonder, we are all on the lookout for easy ways to make money. One of the approximations we do is to figure out departures from a base case described rather than calculate what is the eventual outcome. So in this case, the description of Stock A's 7% chances of falling turns out to be the base case and the second option is evaluated against this. So a 93% chance of rising looks good for Stock B. The mind does not grasp the implications of a 7% fall and 93% rise in the first sweep! In case you managed to get the above test right in one sweep, great show! But be sure to stay away from the many more that abound. Experience comprises illusions lost, rather than wisdom gained. - A French Parish Priest
Welcome to the world of psychology of investing
The recent past has seen the development of a new field in investing that blends economic decision making with psychology in order to understand individual as well as collective financial behaviour. Investors and traders alike get lost in myriad illusions created by the mind that is a big stumbling block for making wise investing or trading decisions. Here is another way "framing" impedes decisions that we seldom recognise. Investors are not as much "risk averse" as they are "loss averse".
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Here is a desi version of classic example that the founding fathers of this discipline, Daniel Kahneman and Amos Tversky, presented to two groups of people. Group I choice set You have Rs1,000 in your pocket and need to choose between one of these two investing options Option 1: A sure shot gain of Rs500 Option 2: A 50% chance to double the money and a 50% chance of making no profits What would you choose? Group II choice set You have Rs1,000 in your pocket and need to choose between one of these two investing options Option 1: A sure shot loss of Rs500 Option 2: A 50% chance of losing the Rs1,000 capital and a 50% chance of losing nothing! Hmm! In their experiments they found that 84% in Group I chose option 1 whereas in Group II, a good 69% chose option 2!! Know why the groups chose those options the way they did? It had to do with the way the options were posed to them. Group II participants had a sure shot loss staring at them as one option whereas the other option presented them an opportunity though half a chance to walk away with losing nothing. Of course, the knowledgeable among you would have figured out that there is nothing to choose between the two options, as they are the same. Hence, as long as the Sensex is climbing 400 points every month, a bullish trader will stomach a 100point fall during a week and see it as a money making opportunity. But when the Sensex is in a downtrend, even a 100-point rally during a week does not enthuse the traders enough! In fact, empirical studies done in the US prove the following: "Positive emotional value of a gain is only one-half to one-third of the negative emotional value of an dollar equivalent loss. For example, a $100 loss causes emotional pain two to three times the emotional pleasure of a $100 gain." This theory is called "Prospect Theory"? Most people feel more pain for losing Rs100 than they feel happiness when they make Rs100.
Which portfolio would you prefer?

Portfolio A has Rs1,000 worth of one stock that appreciates by 10% and Rs1,000 worth of another stock that declines by 15%. or Portfolio B has Rs1,000 worth of one stock that stays flat and Rs1,000 worth of another stock that declines by 5%. There are similar studies done that demonstrate people prefer portfolio B to portfolio A. Why? Portfolio A has one stock that declines by 15% whereas the maximum decline of stock in Portfolio B is 5%. The mind ignores the fact that the other stock in Portfolio A appreciates by 10%.
Hence, most people prefer Portfolio B to Portfolio A though both the portfolios lose the same. Has your curiosity been tickled enough? Keen to fight and take control over your own illusions? Keep following this series. Next time, let us look at many simple cognitive illusions that impede decision-making abilities of investors and traders alike. Till then keep humming to the lyrics of Pink Floyd's "Brain Damage" from their album "Dark side of the Moon" The lunatic is on the grass The lunatic is on the grass Remembering games and daisy chains and laughs Got to keep the loonies on the path The lunatic is in the hall The lunatics are in my hall The paper holds their folded faces to the floor And every day the paper boy brings more And if the dam breaks open many years too soon And if there is no room upon the hill And if your head explodes with dark forebodings too I'll see you on the dark side of the moon The The You You You lunatic is in my head lunatic is in my head raise the blade, you make the change re-arrange me 'til I'm sane lock the door
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And throw away the key There's someone in my head but it's not me And if the cloud bursts, thunder in your ear You shout and no one seems to hear And if the band you're in starts playing different tunes I'll see you on the dark side of the moon "I can't think of anything to say except... I think it's marvelous! HaHaHa!"
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Psychology of Investing Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Linear thinking
Imagine that an investor has two stocks that trade at the same price of Rs100. However, the investor bought one of the stocks at Rs50 where as he bought the other one at Rs140. In such a situation, even if the investor is told that the losing stock is likely to decline further, the reluctance still stays to square off the position. Interestingly, if the investor is told to square off both the positions then the investor works out that there is a profit of Rs10 {(Rs100-Rs140)+(Rs100-Rs50)}. Now, he is more open to the idea of closing both positions! We really hate losses, don't we? Last time, we got to know that we are more 'loss averse' than 'risk averse'. How better to start off the next in the series on "mind traps" than starting with another teaser. These are the profits of two companies over the same period of two years. You just need to choose the likely profits of these two companies in the next one year.
Now it is time to move ahead?
Company A Options Company B Options
Rs (cr) 21 37 ? a) 53 b) 60 c) 65 58 138 ? a) 123 b) 168 c) 210
What were your choices? Don't you think it is logical to assume that Company B's profits would have grown higher than Company A? So Rs53 crore for Company A and Rs210 crore for Company B are logical deductions to make. Well, these are actual profit figures for these two companies for FY1996 and FY1997. In FY1998, Company A reported a Rs60 crore profit while Company B reported a Rs123 crore profit.
Here is one last "complete the series" teaser on these two companies. Again you need to pick the profit figures for the next year.
Company A Options Company B Options
Rs (cr) 60 135 293 ? a) 541 b) 607 c) 629 123 96 72 ? a) 95 b) 51 c) 54
Many of you would have got the profits for Company A right as Rs629 crore. But did you peg the profits of Company B at Rs51 crore or Rs54 crore? Well, Company B reported a profit of Rs95 crore.
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Many amongst you who track profits of large companies would have figured out that Company A is Infosys and Company B is East India Hotels (now EIH Ltd) You must be wondering if there is any method to this seeming madness about company profits. Logic fails? Nay! Business dynamics are a lot more complex. Hence, the profits that are determined by a whole host of variables ranging from market size for the company's products to the fixed overheads that the company bears can never be linear. Ah! the key word. But linear is the way the mind functions. We have stumbled on the next trap that our mind falls for-- to think linearly and hence assume everything works linearly. If you look at the prices of Infosys and EIH during this period you would realise that the entire market was stuck thinking linearly. Of course, Infosys vaulted from Rs1,500 in March 1999 to Rs9,000 by March 2000 as the entire market assumed safely that the profits for Infosys would keep growing at 100% for the next five years. All it took is one slowdown and one round of expectations being rolled down to 30% growth rates. You know what happened to the price of Infosys stock. EIH, on the other hand, arrested its fall after its results 'surprised' the market. In fact, it doubled in three months! Any guesses on what the market expectations are on EIH's results now? In fact, many smart investors wary of this 'mind trap' treat a large consensus in the market trend as an early sign that the trend is set to reverse. So next time you spot everybody around you bullish, think before you leap. The chances are very bright that being a "contrarion" might be the better option! A qualitative result of our mind falling for the illusion of "linearity" is Typecasting. Three stocks have done very well. They are all leasing companies with "Finance" as part of their company name. Next generalization is that all stocks of companies with "Finance" in their name will do well on the bourses! Tech, Info, dot com, and now biotech?the crowd has an amazing ability to fall prey to such traps again and again. There are a whole host of promoters ready to cash in on this. The end result is big speculative manias. Thankfully, this mind trap is on the downswing because of gross misuse. So much for this episode of exploring "mind traps". Next time, a hard-nosed look at the 'herd instinct'.
Business dynamics are complex
Linear?
Beware of thinking 'linearly'
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page The Nature of the Market Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Kissa market ka
You have got richer with the knowledge that owning a share means owning a part of a company. You are aware now that investing in equities helps preserve and enhance the process of wealth generation. You have also learnt that investing in equities is not all only about quick and easy money. ?Khel Risky Hai?. We then discussed how it was possible to make the ?Khel? becomes less risky for you. We discussed how to tame that monster called Risk. You?ve learnt about the basic tools in an analyst?s armoury?PE, RONW, ROCE, Enterprise Value? Welcome to the World of the Informed Investor. You are now armed with the knowledge of why equities are important and how to value them. It?s time we went into overdrive. You are now aware of how to value a stock, but while it all seemed like an intelligent science so far, very often the stock market seems like a mad place. Is the stock market like the vegetable market? Well, the answer is NO. In a vegetable market, there are several links in the chain. The farmer, who grows the vegetables, is the primary seller. But he cannot reach us, the primary consumers, directly. Between the farmer and us are several middlemen, each one with his own cut. The farmer has no idea of the price the consumers (that?s us) are willing to pay and we have no idea of the price at which the producer is willing to sell. What about the market for soaps? Is it any different? To an extent, yes. HLL produces ?Lifebuoy?. But before the product reaches you, it passes through the vast network of wholesalers, dealers, stockists, and retailers. Each one pays a different price before passing it down the chain. However, in this case the producer does set a final price that you would pay. But you do not have the option to bypass the chain. Stockmarket operates at the speed of light The stock market is different. Everybody, starting from YOU to the research analyst, the company insider, the mutual fund, the FII and the trader/operator, participates in the same market . Small wonder that the market works at the speed of light. In the vegetable market, due to the presence of several intermediaries, price responds with a lag to information and events. For instance, if there is a sudden spurt in the demand for apples, prices will not shoot up immediately. The information will travel back to the farmer and if there is a shortage, prices will eventually spiral. In the stock market, price discovery is instantaneous. Information and events are known immediately given that all market participants congregate at one place or on one seamless network. The stock exchange The stock exchange is where all participants converge to determine the price of the product, that is, shares. Ownership of a share indicates ownership of a certain proportion in a company. Imagine a world without shares?it would be virtually impossible to create a business and then be able to realise value for it. Shares enable you to separate ownership from management and allow businesses to be traded in pieces without forcing the company/business itself to be broken down. To the outside observer and even to market participants, the stock market often seems to be a place where no logic works and only madness prevails. But as you continue along this voyage into the world of equities, we hope to convince you otherwise. Only fundamentals work in the long term At the end of the day, it is the fundamentals which determine the prices. Every investor must understand that the fundamental factors which market prices reflect are the sum total of perceptions of all the investors. A seminal work in this context is the ?Rational expectations theory?. Shares prices discount the future, and only the variability of the outcome drives prices.
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For instance, the market expects Tisco to announce a profit of Rs100cr. If the profit turns out to be Rs110cr, the market will react positively, driving up the stock price. The opposite would happen if the profit is Rs90cr. Nobody in this world knows what would happen tomorrow and, therefore, markets are perfect only to the extent of available facts and information. Markets can never be perfect with regard to their expectations of the future. Many times, company insiders would have information about a particular event and their activity may make the stock price move towards a level it would have attained if the event was known in the market. This again is not knowledge of the future but knowledge of an event that has already happened. However, this information is restricted to only a few people and, from that point of view, it is a past event for the insiders and a future event for others (investors please note that insider trading is a culpable offence in India and other countries). Investors active in the stock market have to look at market-sensitive factors. It can significantly enhance your returns on investment if you carefully play these factors. Isn?t it all just about money power? The rules of demand and supply apply to the stock market just like in any other market. At the end of the day, the price of a stock moves up only if the demand from buyers is more than the supply. Therefore, in the short term market participants with huge money power can significantly impact the demand-supply equation and hence prices. Who are the market participants? Literally everybody?the institutions (FIIs, FIs, Mutual Funds, Banks, Corporates), retail investors (You and Me) and speculators & traders. So sure, sometimes it does appear that it is just those few mega speculators or FIIs who are the only ones driving prices. But the market is bigger than just one or 2 of the big boys. Consider: between September 1994 and October 1998 the supposedly big money FIIs pumped in US$6.1bn into the market, but it went nowhere. The reason: without fundamentals, the money power is worth nothing. And while your 100 shares of Cadbury might seem like nothing, think of millions of investors like yourself, all over the country, and that is quite some firepower. What contributes to the mood swings Each of them has a different risk profile, return expectation and time horizon for their investments. Very often, each of them also has different levels of information. So the investor who happens to be a shopkeeper may know ahead of most others that Cadbury?s new ?Perk? variant is taking the pants off the competition.The fact that the stock market is a congregation of people with such different characteristics often results in wild mood swings. There is the retail investor who might be selling because he wants to raise money for his son?s marriage (these days that happens too, you know). But there is also the retail investor who is squirreling away his savings for the day when he retires and might not have a regular source of income. There is the FII who is buying because Asia is suddenly the hottest market in the world. And there could also be the FI who is buying to support the market under government instructions. Add to it the speculator who has a very shortterm horizon?he knows that Badla rates this weekend are going to be high and therefore the market could head lower by the closing today. So, at any given moment, the market trend depends on which of the participants are in control. Ignore the noise factor What about events that receive a lot of attention?budgets, political uncertainty, duty hikes etc? Sure, they have an impact on the market. But what is their real impact on good businesses (read good companies)? At most times, it is too negligible to actually impact the long-term potential of a good business. But almost always, share prices will be super-sensitive to such factors. So learn to accept that the market is going to have its moods; but at the same time, learn to ignore them. What makes this market unique What makes the stock market so unique is that no matter who is selling or buying, there is always a person on the other side. In other words, when somebody is buying, at the same time somebody else is selling. That is logical, isn?t it? If everybody only always wanted to sell or only wanted to buy, then no trading would take place. Of course, trading does stop sometimes when artificial means like ?circuit filters? are forced by the exchange. It is the liquidity of this market and the two-way exchange process that makes it unique. Can you take the vegetables back to the market and sell them? Well, in this market you can do the equivalent. We hope this has helped you to understand better the dynamics of the marketplace?who are the participants and how prices are determined.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page The Nature of the Market Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Speculation aint a four-letter word

Last time, we had mentioned that what makes the stock market unique is that no matter who is selling or buying, there is always a person on the other side. It is the much-maligned traders/ speculators who impart this liquidity to the stock market. This week, we delve deeper into the role of a speculator/operator. ?The stock market is a dangerous place because of the existence of traders and speculators.? My mother used to tell me that the stock market is not the place for anybody?s hard earned savings. But after having invested in some good mutual funds a year back and seeing the returns, she now has a vastly improved opinion of the market. But, mention trading and speculation and the thaw is instantly replaced by a chill. Images of the Big Bull, Nick Leeson, CRB, etc, etc, begin to loom large in her mind. Images of untold misery of thousands of small investors, caused by the actions of these speculators. So, is all trading and speculation bad? Or is mom missing the wood for the trees? The truth is that in the stock market, everybody has a role to play, whether it be the small investor, the mutual fund, the FII or the much maligned operator/speculator. Why speculators? Let us presume for a moment that the market is devoid of any traders and speculators. Then the market would be devoid of liquidity. In other words, it would be difficult to buy or sell stocks without significantly affecting the prices. Enter the speculator. He is willing to take more risks than your average investor; he is willing to buy stocks with a very short-time horizon?days, even hours perhaps. The speculator knows that daily price moves are as much a function of the daily sentiment as they are a function of the fundamentals of a company. And he looks to profit from them. To understand this better, let?s peek into a typical day in the life of a speculator. Bajaj Auto workers have gone on a strike and the price has fallen 8%. I bought Bajaj Auto just a week earlier and am starting to feel pretty sick. But the speculator?he begins to scent an opportunity. Next morning: I?m heading for the exit? The next day, the newspaper headlines scream out that Bajaj Auto?s EPS could fall 3% if this strike lasts more than 10 days. I can really feel a chill going down my spine. Oh my God! If this stock falls any further I would be sitting on a loss, I tell myself. But hey, I am a smart guy. So I?ll sell the stock today and wait for it to fall another 10-15% and then buy it back. ?while the speculator is moving in for the kill Things are going according to plan. I place my order to sell at 10:00 a.m. sharp. The stock opens down 2%, but my broker has an order to sell at the market price and he promptly does so. Guess many other brokers had similar orders as well and soon the stock crumbles a further 8%. Now the speculator moves in for the kill. Fine, Bajaj Auto?s profits may drop 3% if this strike persists for more than 10 days. But the stock is down nearly 16% since the news came out. That may be justified if this strike last longer than 10 days. However, he feels the market has overreacted and starts to buy gradually at the lower circuit (the lowest price that the exchange permits the stock to fall on a day). In the process, he absorbs the selling pressure coming from some other friends of mine who called me in the morning and decided that my strategy was very wise indeed. 1.30 p.m.: The foreigner steps in? It?s now 1:30 p.m. in Bombay; the stock is down only 7% and only some stray trades are taking place. A large foreign fund in London, which has been looking to buy Bajaj Auto for the last 6 months, senses an
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opportunity. This fund manager has a 5-year horizon when he buys a stock. As far as he is concerned, even if the strike were to persist for a month, the impact on the earnings of the company would be only a blip over the 5-year horizon he has in mind. He places his orders for a very, very large quantity of Bajaj. ?and the speculator?s eagle eye detects his presence As his broker in Bombay starts buying, you can see some stirrings of life in the stock. It?s now up 2% from its low. Some more friends of mine think this is a heaven sent opportunity. When they had earlier reached me for advice, there were no buyers in the stock. Now there are buyers 2% above that price. Hallelujah! Promptly, they decide to follow me and place their sell orders too. Our speculator is watching the screen and he now senses that perhaps some other buyer in the stock has emerged. He offers a large-sized block on the screen (only a small portion of his total purchase, though). Immediately, somebody grabs it up. Now he is convinced that there is a buyer. He promptly buys back the small quantity he sold and then a little more. He senses the entry of a bigger fish. Sometime later: more buyers in the ring Shah and Sons is a venerable BSE broking house and has always been positive on Bajaj Auto ever since the stock traded in its late teens. It has a lot of clients who bought Bajaj Auto when it was in the late teens. Having become millionaires thanks to their investment in the stock, they have complete trust and faith in the ability of the company to make it through this strike. Shah & Sons recommends the stock yet again to its clients, who start to buy... It?s 3.00 p.m.: the stock?s recovered? The foreign fund is an unrelenting buyer and by 3:00 PM the stock is down only 1%, nearly 7% above its low for the day?which was when our speculator friend bought his stock. ?and ?short-sellers? are scurrying for ?cover? Enter the short-sellers. They are the guys who sell stocks they don?t have because they think the stock is going to fall. And when it does, they will buy the stock back (the jargon is ?covering?). Some of them had sold the stock yesterday because they expected it to fall further. They were right. It did. Some have covered and booked their profits. But some have not. And now they want to do so too?might as well take home the meagre profit we are still making, they say to themselves. Some of my friends not only sold their existing holdings of Bajaj Auto but also went short (i.e., sold stock they did not possess) as they were very confident that the stock would drop further. As their brokers called them with the bad news that the stock had gained since they had short sold, they panicked and asked their brokers to buy back the stock they had sold short. For them, it is now only a question of reducing their losses on the short trade. It?s closing time?and party time for the speculator Now the action is really heating up. With just 15 minutes to go, the stock is now trading 1% above yesterday. Our speculator friend had made 9% in just a day. Meanwhile, some funds which have been sitting on the fence wondering when to make their purchases start feeling left out. They come rushing in to buy. Our speculator friend decides to cash in his chips. As these new funds and the shortsellers come charging in to buy, he starts to sell. For the next 15 minutes, the stock is extremely volatile, rising nearly 4% above yesterday?s close?the speculator sells all his stock. Post script: not every day?s as good It?s not always a happy ending like this for the speculator. Sometimes, he can be spotted drinking away his sorrows late into the night at Mahesh Lunch Home, in the vicinity of the BSE. But today he had a good day (calls for nothing but Geoffreys). He took a contrarian view (we would call it a common sense view) and profited from it. He provided an exit route for distressed sellers like me and provided supply to the few funds who came late to the party. In the process, he made a neat profit. But as I said earlier, sometimes he makes a loss as well. So that then is the role of a speculator?he provides liquidity by buying when (nearly) everybody else wants to sell, and by selling when the opposite happens. In the process, he matches time horizons as well?my limited time horizon which made me decide to sell with the idea of buying back later, with that of our London-based FII who decided to buy with a 5-year view. He provided the liquidity. He did it because he knows that all the players in the market have different time horizons and expectations. He just helps bridge the gap. After this, I hope you will all have something good to say about the speculator. Mom does! (All characters and events in this write-up are fictitious. Any resemblance to real-life characters and/or events is purely coincidental.)
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You know the basics. Now you are eager to know how to make money. Learn the tricks of being a smart investor. Chapter 1: The Nature of the Market Chapter 5: Investing Styles Chapter 3: Investment Strategies Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing
Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Chapter 2
Badla is not the name of a Bachchan starrer. Its nothing but a leverage mechanism Article 1: Allaying the liquidity fears | Apr 2 2001 Why you should welcome rolling settlement with open arms. Article 2: Rolling settlement demystified | Mar 27 2001 Why an investor should not be afraid of this in the stock market? Article 3: Ups and downs of leveraging | Nov 12 2001 What do you think Archimedes has to do with finance? The Greek philosopher had realised the pow... Article 4: Talking badla with a vengeance | May 15 2000 Badla is a mechanism to offset outstanding transactions at the end of settlement. How does it w... Article 5: Aur bhi badla- The plot thickens | Jun 23 2000 Get to know how 'Badla' really works in the market...
Chapter 2: Understanding Markets Better
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Article 6: Make money out of thin air | Oct 4 2001 Arbitrage. That's the other name for a free lunch. A lunch that is cooked up by exploiting pric... Article 7: The making of 'Booms' and 'Busts' | Mar 30 2000 Can the market as a whole keep borrowing and investing to take the Sensex up endlessly? Sadly n... Article 8: Taming of 'Booms' and 'Busts' | May 24 2000 The margins are the regulators way of restoring sanity in the market. Heres how t... Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Understanding Markets Better Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Allaying the liquidity fears

As an investor, you should welcome 'rolling settlement' with open arms. But then you would probably ask- 'What about liquidity'? We parted here last time after raising the specter of a fall in liquidity post introduction of rolling settlement in the stock market. Liquidity is popularly understood in the market as transaction volumes on a stock exchange. However, sometime later, we will understand the true meaning of 'liquidity' and its dimensions. For now, let us stick with the popular notion of liquidity while we take a look at the popular belief that rolling settlement leads to a drop in volumes on the stock exchanges. Since traders who take positions for five days in a normal five-day settlement market account for a good percentage of daily transaction volumes, a logical conclusion would be to assume that those volumes would disappear. But then will the volumes drop at an aggregate level? Will there be no new form of participation, which will add to the volumes? Will new investors not enter the market now that it is a much safer place for them? Stock markets and Mumbai roads! A better way to understand this quandary would be to draw an analogy between the stock markets and roads of Mumbai! Like stock markets help investors buy/sell stocks to create wealth for themselves, similarly roads help people to reach from one place to another. Travelling in Mumbai by road means spending many a frustrating moment stuck in a traffic jam. Now imagine a day when the autorickshaws and taxis are on strike! This has happened many a times... Here are some numbers to help you understand the situation a lot better. As per the 1991 statistics, there are some 55,000 taxis and 1,00,000 autorickshaws in Mumbai. Mumbai roads can carry a maximum of 2,50,000 vehicles at any given time. Hence, a strike by the taxis or autorickshaws would mean 1,50,000 less vehicles on the road at any given time. A typical question that can arise is will people face problems reaching wherever they need to in Mumbai? Similarly, a stock market participant would ponder as to what would happen to market volumes during a rolling settlement? On the other hand, people who drive their own vehicles will be a happier lot. They would get to drive on emptier roads without watching out for the rickshawallahs flying in from any side onto their paths or for that matter the guzzling smoke of a cab in the front at a traffic signal. Of course, encouraged by lesser traffic on the roads, there are a lot more who would venture to get their vehicles out. The rest would take to the buses. In such a scenario, normally, the number of bus services gets increased. Of course, we have not forgotten the trains that serve commuters very well. Many more might crowd the trains.
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In short, life goes on and interestingly noise and air pollution reduces sharply! You will find very few Mumbaites who would complain of these days. May be, if the strike continues the city will find better alternatives. But for people who have not seen a cabbie strike in Mumbai, this may seem like the end of the world or should we say end of the road
Hmm! Rolling settlement could keep the autos and cabs away from the stock market. But pollution levels would drop sharply making life a lot better for the investors. In fact, many people (read small investors) would not feel threatened to ride cycles! Markets always adapt to change Before we make a case for how this would result in better forms of liquidity in the market, it probably makes a case to check what happened in some other stock market when they switched from a fiveday normal settlement to a rolling settlement. It is interesting to note that rolling settlement has been embraced by most developed stock markets in the world. So, we need not look far away for a good example. London Stock Exchange had a settlement system very similar to ours (or should we say we borrowed it from them). They shifted to a rolling settlement system in July 1996. Check what happened to the volumes of the market.
Year 1991 1992 1993 1994 1995 1996 1997 1998 1999
Shares Traded (m) 155412 181940 215456 221832 230318 239618 280254 259370 335459
Value (m) 360460 433858 563967 606002 646332 741619 1012535 1037137 1410590
The growth rate in exchange volumes dropped for a year only to pick up from the next year as though nothing had changed. That talks volumes about the stock market's ability to adjust to changes faster. In fact, in 1994, when BSE shifted from a ring-based trading to on line trading there were big concerns that the stock market would lose its efficacy. Jobbers who provided liquidity to the system would not exist on-line et al. A good six years later, we have not only witnessed the participants adapt themselves but also volumes rise manifold. In fact, the lack of a properly functioning depository made it difficult for us to have 'rolling settlements' in the past. Imagine a trader in Assam receiving physical shares from his broker in BSE, which he wishes to sell the next day. But today, the market is a lot different with online trading in place, most stocks in the dematerialised category and electronic fund transfer soon becoming the order of the day. Hence, with the introduction of rolling settlement, our stock market minus the fiveday normal settlement that exists today will serve its true purpose. The true purpose of being an actual 'cash' or 'spot' market, as they are popularly known where investors allocate capital to businesses based on their performance only rather than taking punts on the market direction. On the other hand, the derivatives market will help genuine investors manage their risks. Hence, risk allocation happens in such markets. This division makes investing in stocks a lot safer. Of course, a healthy arbitrage between the two markets will provide for increased volumes in both the spot and derivatives markets. On a later stage, we shall understand these aspects of the markets a lot better. We shall understand the basis for the existence of the spot market and the derivatives market a lot better. In the process, we will also understand the various dimensions of market liquidity.
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Rolling settlement demystified

"Rolling settlement" has acquired the same notoriety as "devva" (devil in English) that is used by parents (from the southern part of the country) to scare kids who give them a difficult time. Rolling settlement, as a glossary would define it, stands for a settlement mechanism in a stock exchange where outstanding transactions at the end of every trading day result in delivery of shares and receipt of cash. Whereas in the normal settlement system, the outstanding transactions at the end of seven days (inclusive of a two-day weekend holiday) result in delivery of shares and payment of cash. Hence, the current system is like a five-day futures market. Suppose a trader wants to buy a stock on Monday--the first day of a new BSE settlement--with the intention of selling it on Thursday of the same week. In the current system, the trader needs to just pay up the margin. On Thursday, when the position is squared off, the trader would take home the profit or pay up for the loss. However, in a rolling settlement, the trader will have to make the complete payment for the outstanding long position on Monday. On Thursday, squaring up the position is a separate transaction altogether where the trader would deliver the shares he purchased on Monday. Hence, in the current system, traders who hope to profit from a price rise or decline in the five-day period play a very active role in the market. Thereby making the current spot market more of a five-day futures market. On the other hand, under the rolling settlement, the role of these traders who treat the spot market as a five-day futures market is marginalised as each of their transactions necessarily results in delivery of shares and a receipt of payments. Why are rolling settlements useful? From an investor's perspective, rolling settlement reduces delays. Shares sold on, say, Monday result in money being received on the next Monday. As the system becomes more efficient in the future, we will even see shares sold on Monday resulting in funds paid out on the next day. Hence, shares will become more liquid as they can be converted into cash in a jiffy. Rolling settlement also has another good economic outcome. Since it prevents traders from taking positions akin to the usual 5-day futures market style, this reduces the tendency for price trends to get exaggerated. Hence, investors not only get a better price but also can act at their leisure. Economics textbooks would classify this as 'price discovery'. Just try to remember the various occasions in the past when after painstaking research you had spotted a right stock that traded at Rs105 and you expected it to go to Rs150 in three months because of a certain division doing well. But then you wanted to buy this stock at Rs100. However, on Monday you woke up to read your financial newspaper that had this news on its front page. You decided to buy it between 105 and 110. The stock opened at 110 and reached 115 by the end of the day. Remember there are a whole host of traders who spot an opportunity to make a quick buck within the five days settlement cycle (aka futures market). You were forced to buy it at 120 on Tuesday. Three days later when the settlement was about to end you noticed the stock trade at 108
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Know why this happened? For every one investor like you there was more than one trader hoping to make a quick buck. In the process, not all of those traders make money but they end up making your purchase price very dear. Hence as an investor in the market, you should welcome 'rolling settlement' with open arms. But then you would probably ask- 'What about liquidity'? Though these traders profit at the expense of investors in general, there is a school of thought that believes that the profits investor's part with is marginal considering the critical liquidity that these players provide to the market. Here lies the strongest argument against the rolling settlement system--the lack of liquidity. Next time, let us take a hard look at this 'liquidity problem' that hangs like the Sword of Damocles over the implementation of a rolling settlement.
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Ups and downs of leveraging

"...panic unwinding of margin trading positions led to the 1987 crash on Wall Street..." "...excess leveraging has led to the creation of a bubble in the market...." "...SEBI imposes higher volatility margins..." What is leveraging? What is margin trading? How do these exaggerate market movements? "Give me a place to stand on, and I can move the earth"? Archimedes, the great Greek philosopher, was confident of achieving this because he had realised the power of 'leverage' - the action of a lever. A lever is a simple mechanical device that rests on a pivot and helps lift a heavy load with minimum effort. What is the connection with finance? During our session on capital structuring, we learnt how companies borrow capital (debt) to enhance return on equity. The expectation of companies is that they would be able to get more returns than their cost of debt, and hence improve the return on equity. How does leveraging work in the securities markets? Just like companies, security market participants believe that if they can earn higher returns than their cost of borrowing, they will be able to boost their returns on capital. Hence, leveraging in the securities market refers to money borrowed to cover part of the cost of purchase of a security. And in our context, security stands for stocks. Did you say part of the cost? Yes. Remember that companies start with equity capital for their business before borrowing to leverage that equity capital. Similarly, stock market participants have to bear part of the cost that covers their commitment. In stock market language, the upfront money that the participants pay is called 'margin'. The balance is borrowed at a certain cost. How does it help? Let us take a simple example. Assume you figured out that Infosys would go up by 15% next week. You have Rs1,10,000 at your disposal. If the closing price of Infosys is Rs11,000, you will be able to buy 10 shares. In case the stock does move up by 15%, you will end up with stock worth Rs1,26,500 (Table 1: Case A). Now, imagine if somebody offered to finance your purchase on the condition that you pay up 20% of the value as margin and pay him a borrowing cost of 0.25% per week. Taking Rs1,10,000 as your 20% contribution, the lender would be ready to fund you to the tune of Rs4,40,000. Then, you could actually take a position in the stock worth Rs5,50,000. In other words, you could buy 50 shares of Infosys. Now assume that the stock gained 15%. You sell your shares for Rs6,32,500. After you repay Rs4,40,000, the borrowed money, and the interest of Rs1,100, you would be left with Rs1,91,400. Adjust it for the capital that you placed as margin money. Lo! Behold! You have a profit of Rs81,400 or a return of 74% in one week! Look at what leveraging can do for you. (Table 1: Case B).
15% Price Rise Case A Case B
15% Price Fall Case A Case B
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Capital Borrowing Infosys Purchase Value Realised Value Cost of Borrowing Profit RoI (%)
110000 0 110000 126500 0 16500 15.0
110000 440000 550000 632500 1100 81400 74.0
110000 0 110000 93500 0 -16500 -15.0
110000 440000 550000 467500 1100 -83600 -76.0
What if the stock falls? A good question indeed. Let us rework the profits in the event the price falls by 15% instead of going up 15% in the period under review. The 50 shares of Infosys will be worth Rs4,67,500. After repaying Rs4,41,100 to the lender, you would be left with Rs26,500. In other words, a loss of Rs83,500 or minus 76% in one week! It can almost wipe your entire capital. If you had not leveraged, you would have lost only 15%. (Table 1) So, how does the lender protect himself? The lender runs a big risk of the borrower defaulting. Hence, he normally increases the 'margin' requirement to compensate for the decline in market prices in order to protect his capital. A double-edged sword Leveraging is a double-edged sword. You can expect phenomenal returns despite taking on a fixed cost if your instinct is right and the market plays itself out according to your expectations. But if it does not, the results could be catastrophic. In the next part, we will relate leveraging and margin trading to the carryforward system that is prevalent on the Bombay Stock Exchange (BSE) - the badla system. We will discover how the carryforward system handles 'marked to market' margins. We will then try to understand how leveraging impacts our market. We will also try to cover how leveraging creates market bubbles, and how traders who stay leveraged lose out in the long run.
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Talking badla with a vengeance

A local brokerage house, round the corner. A big client calls up and orders the dealer to buy 20,000 shares of ITC and instructs him to keep it in ?Badla? (?) A leading stock operator with a big position in one scrip is busy ramping the price on Friday to ? chchapo? a good ?Hawala? rate for his ?Badla? (??) The head of treasury of a finance company has put up a proposal to the CEO to get a clearance to place his short-term fund surplus in ?Badla? (???) A smart trader, noticing that ?Badla? rates have increased in the last two weeks while the market has gone nowhere, decides to sell his long positions and put his money in ?Badla??(????) A leading pink newspaper?s bold headlines read: ...The ?Badla? positions are huge and the market is likely to fall... (?????) The Taj Conference room is hosting a symposium on equity futures. A doyen of Indian equity markets is speaking on ?Badla vs Futures? (??????) ?Badla?...a five-letter word that means six different things to six different people. And we all thought it was what Big B did to the villains who killed his parents in ?Coolie?! We checked with an expert on the subject... Settlement mechanism The existing settlement mechanism on the BSE is a fixed 5-day settlement period that begins on Monday and ends on Friday. The trades for these five days are aggregated and the net positions at the end of the session are settled. The participants for any session can be classified into three categories:
the investors, who buy stocks clearly with the intention of picking up delivery of shares by paying for their purchase; the traders, who use the session as a 5-day futures market and square off transactions within the settlement; and, the traders who desire to pick up delivery but are not capable of funding the transaction.
Capital unrestrained What does a trader who does not have the money do to fund his transactions? Simple answer?borrow. But how? Borrowing is not simple as the individual?s credit rating will have to be assessed. Some people will have access to cheaper money because of some clout, whereas the rest will get it at exorbitant rates. But the lenders are likely to insist on a fixed tenure for the loan and steep penal rates for pre-payment. The trader (borrower) runs the risk of borrowing for a fixed term to fund equities that are very volatile (we all know the 2-days? upper circuit and 3-days? down circuit routine very well, don?t we?). Enter the leveler The ?Badla session? is a mechanism that is set up exclusively to offset outstanding transactions at the end of the settlement. It ensures that the borrowing rates (?Badla?) are market-determined and, hence, fair to all the participants. The exchange stands between the lender and the borrower, thereby mitigating the individual credit risk. The ?badla session? in its original form was envisaged as a borrowing mechanism at a rate determined by the market. This happens in a situation when the cash starved traders outnumber traders who do not
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possess the stock they have sold in terms of value (net long position). However, sometimes the ?badla? session also functions as a ?stock lending? mechanism. This event occurs when the traders who do not have the stock outnumber the cash-starved traders (net short position). The lacunae in the system is that it functions at the aggregate level. As a result, a person might have short sold a stock but since the market position is net long, he will be paid ?badla? while carrying forward his short position. However, whenever the market position is net short sold, short sellers end up paying while the net long position holders make merry. The charge paid by short sellers is called ?Undha Badla?... (It was a mistake to have asked an expert about this subject. Half the stuff went over our heads. Let us check with a dealer...their explanations are far more lucid and practical)
Traders in need Let us assume that Harshad buys 10,000 shares of ITC @ Rs950 per share. After all the innumerable trades during the week, he is still left with this position. Harshad Bhai does not have money but desires to carry forward his transaction as he knows (!) that the company will announce a bonus next week and the stock will fly. Therefore, he instructs his broker??Borrowmore??to put it in the ?Badla session?. The provider Munshiji is a rich merchant with a lot of surplus funds as he pays his suppliers 15 days after his customers pay him! He detests trading or investing in equities as he believes that traders like Harshad Bhai have reduced it to a gambling den. He dreads losing his (?) capital, but the lucrative yields in Badla are too attractive to ignore. He instructs his broker??Avenger??to put his funds in badla. Meeting ground Friday?s close of ITC was Rs1001, so the Hawala rate for Saturday?s badla session has been rounded off to Rs1000. Borrowmore puts Harshad Bhai?s quote as 10,000 shares to offer @ Rs5 per share (the badla charge) along with the many other quotes for his other clients. At the same time, Avenger is scanning the screen looking for a good deal for Munshiji. He spots the Rs5 quote and hits it, without knowing that it is Harshad Bhai?s quote...had he known, he would have countered the quote at Rs6 per share! He doesn?t care as he is not lending to Harshad Bhai directly but to the exchange, which acts as a counter-party for each transaction. Satisfaction guaranteed As a result of this trade, Harshad Bhai has been able to offset his transaction for this settlement at Rs1000 per share (the Hawala rate) while opening a new buy position starting Monday @ Rs1005 per share. In the process, he has paid Rs5 per share (the difference) but has ensured that he still benefited by ramping the price on Friday to 1,000 so as to improve his cash flow at least for the settlement (remember, his price was Rs950, so he still takes in Rs50 for the settlement! Next settlement, he may have to cough up but then tomorrow is another day! Ha! Ha!). Munshiji is also all smiles as he pockets the Rs5 per share for helping to shift positions for one settlement, one week?an yield of 0.5% per week or 26% annualised. For a similar risk profile, he would have got 0.2% per week or 11% annualised! He has reason to feel happy. (Bahut hogaya! Next time we will find out more about how those analysts and traders use these badla positions and badla rates to figure out short-term market trends. Then of course, there is a whole new gamut of issues?economic functions of badla, regulatory issues (taming greed) and Badla vs Futures!! We thought it was a simple thing, but it is a book in itself! More of all this soon. Let us digest all this lest we suffer a bout of indigestion!)
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Aur bhi badla- The plot thickens

Last time, we had discovered that the ?badla? session on weekends is not a boxing match between the bulls and bears in the old unused ring of BSE?s famed rotunda, where each tries to take revenge. Instead, we figured out that ?badla? is a system that allows traders and speculators alike to transfer positions from one settlement to the other by offering a market determined borrowing mechanism. We also discovered, by looking at the activities of Harshad Bhai and Munshiji, how the system helps speculators like Harshad Bhai to leverage positions while money lenders like Munshiji get fantastic returns. The interesting fallout of this system is that short sellers get to carry forward their positions too and can earn badla for doing that! We had left an unfinished agenda of learning more about how traders use badla positions and badla rates to figure out market trends and also touch upon issues like ?Badla vs Futures?, regulations and economic functions of badla. We are back to address the unfinished agenda!
A pink paper?s market commentary: ?Market fell as badla rates hit 35%... So what, you ask? Why should it fall? We decided to check with a keen market observer, Mr. Shah. He has been around ever since trading began on Dalal Street! Mr. Shah: As you would all know, the market is the sangam of a varied set of traders and investors with different views and investment horizons. The market is also an interplay between fundamentals (or the valuations of businesses against visible earnings stream) and sentiment (that factors in future expectations). Let us try to understand how badla captures useful information that can help predict market trends through the activities of my own two sons! Ketan, my eldest son, is a smart trader who has seen me learn the hard way and has gained better insights. Amit, my younger son, is more impressionable and has taken to trading recently, relying on others for tips. Ketan Bhai smells a bull market... During the third week of April 1999, Ketan Bhai suddenly became very bullish. The big brokerage houses were talking of 5000 Sensex level by March 2000. The FIIs were pouring in money. The government had fallen but everybody expected BJP to come back. There were reports of the economy recovering. Ketan Bhai?s eyes turned big with the desire to make lots of money and retire! However, he had just a few crores at his disposal that constrained his ability to take big bets. Ketan was very convinced about his call and desired to leverage his wealth to the hilt. The ?Badla System? gave him an opportunity to do it too. "Why not," he said! Badla to the rescue Ketan Bhai was a smart trader who did his homework regularly. After all, there are no gains without pains. He pulled out the latest newspaper and scanned the pages to look at the badla positions. He heaved a sigh of relief, comfortable with the fact that the badla positions had dropped to Rs1017cr while the badla rates hovered around 16%. Ketan Bhai did some back-of-the-envelope calculations. A Sensex of 5000 by March worked out to a 40% return (Sensex then was around 3500). With average badla rates always working out to below 30% for a year, Ketan Bhai stood to pocket the 10% spread on one fifth his exposure (remember, traders need to put in margin money compulsorily plus other ad hoc margin requirements) - a 50% return for the year!! Ketan Bhai?s eyes popped out. He rushed straightaway to his broker and bought Grasim, Infosys and M&M. Amit, on the other hand, believed that this euphoria was short-lived. He felt that FII money was all hot money that would leave in no time. He felt that the sentiment was bad, otherwise everybody would have taken big positions on badla. So, he stayed away.
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Market & badla move in tandem Two weeks went by and there was no let-up in FII buying. The market soared past 3800 in just over a week?s time. The smarter traders jumped in headlong, lest they lose out on the rally. Our friend, Amit, on the other hand was utterly confused. Though he thought that it was set to reverse, everyone around him was shouting ?Teji? ?Teji? and jumping in. Ketan Bhai, on the other hand, was very happy with his performance and closely monitoring the badla rates and positions. The market got past 4000 in this frenzy. Amit could wait no longer. He called up his broker and asked him to buy Rs50lac worth of stocks in carry forward position (positions that are carried forward from one settlement to another through the badla system). Chart 1: Market & Badla move in tandem
Market gains too much of fat The second week of July, the index closed at 4639 levels. The badla positions (the fat of the market) had increased to Rs1346cr. The broker called up Ketan Bhai and informed him that the badla rates had shot up to 22%. Ketan Bhai raised his eyebrows on hearing the rate and reworked his calculation. The market had risen too fast for comfort. From these levels, the market had almost reached his 5000 target by year-end, an upside of just 9% whereas if he opted to be the financier, he could pocket 22%! Ketan Bhai also figured out that with the market having risen so much and badla positions increasing now, it would need Herculean amount of buying or some very positive triggers like a landslide political victory, record monsoons and fantastic results from corporates! Too much of hope! Ketan Bhai resolved to sell all his stocks on Monday. Amit, on the other hand, was quite enthused by the index closing and big badla positions. He decided to buy more on Monday and carry the positions forward! Next week, the market opened with a bang as everybody rushed in. Ketan Bhai sold happily and left instructions with his broker to put his money in badla, i.e., act as a financier. Amit stretched to his limits and bought more stocks. Ketan Bhai flew to Goa that weekend to celebrate. The plump market collapses The subsequent week, the market opened higher. But with everybody having built positions with a shortterm horizon and FII buying reducing, the market lacked momentum. To add to the woes, the local institutions started selling. That week, the market closed lower. Amit started twiddling his fingers before the badla session. The badla rates shot up to 24% while positions had also increased to Rs1538cr. Ketan Bhai had a big smile on his face after he heard about the badla rates from his broker. Amit started losing big time as the market began falling sharply subsequently, with FIIs also pressing for sales. He had paid a higher badla rate that added to his cost while the market had come off 10% in absolute terms. Most traders like Amit rushed to square off transactions in a hurry, sending the market to 4488 levels. Meanwhile, Ketan was comfortable with a 5500 Sensex level (The same brokerage house was after all talking of 6000 now!). Suddenly, the upside looked better for Ketan Bhai (25% assuming a Sensex level of 5500 by year-end!). Ketan Bhai called up his broker to ask him to buy stocks and keep it as a carry forward position. The cycle continues... Mr. Shah: Badla offers an outlet for traders like Ketan Bhai and Amit to trade. It provides scarce capital to traders willing to take the equity risks. Thereby, it ensures better volumes and higher liquidity in the market. However, badla can be a double-edged sword, as it can create a bubble in the market that gets crushed. In other words, over-leveraging will lead the market to run ahead of expectations, scaring longterm capital away from the market by skewing the risk-reward ratio. In the process, markets can be fairly volatile. The unfortunate situation with our market is that capital allocation and risk allocation happen together, as there is no futures market! Ideally, cash markets should only serve the purpose of capital allocation, while the futures market facilitates risk allocation through hedging and speculation! Our market is like the Ganga - the holy water is used for all kinds of unhygienic activities!! Mr. Shah?s making sense but he is being very abstruse (abstract!). Let us handle this topic next time.Soon, the chapter on badla will stand closed. Till then, happy badla!!
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Make money out of thin air

A series of statistics carried in the pink dailies scream: "Arbitrage Opportunities". A friend of yours working as a dealer in an FII brokerage house is difficult to catch hold of as he is busy doing GDR arbitrage. A big hedge fund that your neighbour works for arbitrages S&P 500 futures and the S&P Index. "Arbitrage! Arbitrage!!Arbitrage!!!" Ever wondered what this arbitrage is all about? Why not try and learn it from the streets for a change Mr. Arb King is a smart smalltime vegetable trader operating in the Juhu (a posh suburban area in Western Mumbai) vegetable market. He is always on the look out for opportunities to buy cheap vegetables from one place and sell them at a higher price in the Juhu market for a good profit. One day, as he was passing through the vegetable market in Santa Cruz (West) (a neighbouring suburb), he heard a vendor cry: "Tomato lelo, bus chhe rupaiya kilo". Mr. Arb King, who was on his way to his uncle's, stood stupefied as he heard the vendor's cry. They must be out of their minds to sell tomatoes at Rs6 a kilo when I sell the same stuff for Rs9 a kilo just a few kilometers away, he thought. He checked around and discovered that almost all vegetables sold cheaper here, but tomatoes were the cheapest. Maybe people here ate fewer tomatoes than did the rich people in Juhu. Anyway, who cared! Our Mr. King was a trader at heart and he instinctively smelt a profit. He had a bright idea. Why not buy from Santa Cruz and sell at Juhu. Purchase, say, around 30kg of the stuff at Rs6 a kilo from Santa Cruz and sell the same at Rs9 a kilo in Juhu, where the rich men seemed to have a soft spot for this particular vegetable. It would cost him Rs180 (assuming he would not bargain for a better price, which he would anyway), and he could make a neat profit by selling at Rs9 per kg (Rs270 per 30kg!) in the Juhu market.
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So, what did Mr. Arb King capitalise on? Mr. Arb King was not well read but he had enough common sense to figure out that tomatoes at two places not far apart cannot trade at a big price difference. Your economics textbooks will also tell you that any two similar goods with the same utility function (i.e. the same level of customer satisfaction) should quote at the same price. What about cost incurred in transporting the tomatoes? Of course, Mr. Arb King needed to factor in the transport costs between Santa Cruz and Juhu. A cab trip was enough to transport his 30kg of tomatoes. The cab trip meant an additional cost of Rs30. Mr. Arab King started reworking his margins. It all worked out to a neat profit of Rs60 per 30kg of tomatoes sold! All for just an hour's work! Mr. King's trading instincts were aroused and he set about making a quick buck. What happens if the price difference is actually higher? Smart traders like Mr. Arb King will notice that there is a profit to be made. Hence, they will buy from the place where the item trades cheaper, to sell it where it commands a higher price, and make a cool profit from the transaction. Better still, if they can negotiate in such a way that they can execute both ends of the transaction at the same time, then, the business becomes absolutely risk-free. Because under the circumstances, they would not need to worry about any price changes that may happen while they are moving from the lower price point to the higher price point. Literally a free lunch. Economics text books will call the above set of actions "arbitrage" - an attempt to profit by exploiting price differences of identical or similar goods, in different markets or in different forms. Ideally, arbitrage is a pair of opposite transactions that take place simultaneously and generate profit with zero risk. People like Mr. Arb King will be branded as "Arbitrageurs" Coming back to our Mr. Arb King. Though a profit of Rs60 per 30kg of tomatoes does appear to be a small amount, imagine if he were to earn such profits every day for a whole year! Do the sums and you will figure out that he would make more than Rs20,000 from nothing! Yes, money from nothing! Give me a break! Can these profits last for long? You have a point. Let us see what happened at the Juhu and Santa Cruz markets once Mr. King started exploiting the arbitrage opportunity. Mr. Arb King's frantic selling of tomatoes in the Juhu market without much sweat on his brow did not go unnoticed. One of the other traders, Mr. Jealous Guy, caught up with our King's activities. He decided to start the very next day to make his share of profits. No sooner decided than done! He got 20kg of tomatoes from Santa Cruz. In order to wean away Mr. Arb King's customers, Mr. Jealous Guy dropped his price to Rs8.5 per kg. This competition went on for a week, bringing down the price of tomatoes in Juhu to Rs8 per kg. Meanwhile, a vendor in Santa Cruz, sensing the rise in demand for tomatoes, with both Mr. Arb King and Mr. Jealous Guy becoming regular
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buyers, hiked his price to Rs6.5 per kg. This hit Mr. Arb King's business hard and he saw his profits dwindle from Rs2 per kg to 50 paise per kg. Soon Mr. Arb King walked away in search of greener pastures. In the meantime, Mr. Me Too got into the act too. In his exuberance, he started selling at Rs7.5 per kg. What are the profits up for grabs now? The price of tomato in Santa Cruz was Rs6.5 per kg, making the 30 kg of tomato more expensive at Rs195. The transportation cost stayed the same at Rs30. But at a selling price of Rs7.5 per kg, the realization was just Rs225. So sad! No more profits. At the end of it all, the residents of Juhu got tomatoes at a cheaper price while the vendors in Santa Cruz got a better price for their tomatoes. And the arbitrageurs like Mr. Arb King and Mr. Jealous Guy made hefty profits from their arbitrage, which, in turn, made the market more efficient or a fairer place, where nobody got anything cheaper than anybody else. Like tomatoes, financial instruments like shares, bonds, futures, et al, can also be arbitraged. In fact, it is easier in case of financial instruments as they are very clearly defined. After all, a share of Reliance is the same whether it is listed on the BSE or the NSE or as a GDR in Luxembourg, as it represents the same percentage of ownership in exactly the same business.
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The making of 'Booms' and 'Busts'

We have come a long way in understanding how leveraging works in the stock market. We have learnt how leverage is a great ally when used well (remember our double-edged sword?). In our 'Talking 'Badla' with a vengeance' , we discovered how traders like Harshad Bhai get to borrow funds at rates determined by the market while lenders like Munshiji fund their positions. Our stock market has a great mechanism called 'badla', which allows traders to carry forward their positions across settlements. We have also gone a step ahead to learn how higher badla positions and badla rates pull the market down.
Now, lets get down to more basic questions. Can the market as a whole keep borrowing and investing to take the Sensex up endlessly? How does the market work? How do bubbles get created in it? How does the party end? What happens to traders who are heavily leveraged?
Oh! A lot of questions indeed. Let us answer all these questions by simulating a market. Academicians will call this a 'thought experiment'. We have three people to help us out - Mr. Operator, Mr. Small Fry and Mr. Sucker. Mr. Operator is a seasoned stock trader who has access to information and has a nose for good stories that can generate interest in the market. He picks his stock early, takes big positions in the stock, whips up sentiment in the stock, and actively trades in the stock. He takes all these big chances because he is in it for big money. Mr. Small Fry is also a stock market veteran. However, he is a little unsure of his abilities to take big bets. He keeps track of price movements in the market. He spots any high level of activity in a stock very early and jumps in. He also keeps an eye on Mr. Operator's actions and tries to follow him. Mr. Operator is aware of Mr. Small Fry piggy- backing on him, and always tries to shake him off his back. Anyway, that is a different story altogether. Mr. Sucker, on the other hand, has a love-hate relationship with the market. He cannot resist watching stock prices going up and others making money. He is eager to get a piece of the action. However, he normally arrives just when the 'money making' part is about to get over. He then starts hating the market for losing money on his trading positions. Yet, tomorrow is always another day for him. Let's get started on the experiment... In May 1999, there was a lot of hype in the market over pharma stocks. Indian companies were discovering molecules. MNC pharma companies were doling out big payments for these molecules... During those exuberant times, our friend, Mr. Operator was travelling business class to New Delhi. The passenger next to him was Mr. C.E. Om Prakash, head of a pharma company, Example Drugs Ltd. (Neuters Code: EgDg). During the course of their conversation, Mr. Operator got to know that Mr. Om's company had just discovered a new drug. June 7th 1999 (Monday): Neuters: EgDg 100 Mr. Operator has done some homework. He is very excited about Example Drugs Ltd. He asks his dealers to buy every share available. The stock is quoting at Rs100. He has Rs10lac of capital. There is carry forward facility available for Example Drugs Ltd. and our friend builds up a position worth Rs66.67lac (at 15% margin, the Rs10lac capital can be leveraged). The stock closes for the week at Rs135 (eventually the hawala rate for 'badla'.)
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Table 1 Mr. Operator Eg. Ltd. 1999 Mkt. Pr. Org. Cap. Org. Expsoure Marked to Mkt. 7Jun 12Jun 14Jun 19Jun 21Jun 26Jun 28Jun 3Jul 100 135 140 165 171 180 185 155 1000000 1000000 1000000 1000000 1000000 1000000 1000000 1000000 6666667 9000000 9333333 11000000 14000000 12000000 12333333 10333333 -4334545 2159454 2159454 4444444 4444444 2333333 2333333 P&L (Hawala Diff.) Add. Exp. His Capital Add. Exp. (Marked to Mkt) 0 0 15555556 15555556 29629630 29629630 14396361 0 6666667 9000000 24888889 24888889 41029630 41629630 26729695 10333333 -1000000 1333333 -1000000 3444444 -1000000 1159454 -1000000 -5334545 1000000 Net Cash Flow
Total Exp.
His position is worth Rs90lac now (Refer Table 1). As we had seen in our 'badla' sessions, the higher hawala rate means that Mr. Operator will realize a fresh cash flow of Rs23.33lac (the profit on his position). Of course, the learned ones among you will note that he will have to pay 'badla' charges. However, in order to simplify our learning, we are assuming that the 'badla rates' are zero. After all, our objective is to understand how it all works and not to figure out the amount of money that our friend makes. June 14th 1999 (Monday): Neuters: EgDg 140 Mr. Operator has had a great weekend. He is back with renewed energy. He decides to use his improved cash flow of Rs23.33lac to build a fresh position worth Rs155.55lac (remember the hawala difference that he pocketed? We suggest you read our previous 'Badla' write-ups to understand how it works). Meanwhile, our friend, Mr. Small Fry has spotted the sharp rise in the share price of Example Drugs Ltd. (EgDg). He, too, has done his homework. As he walks into his office, one of his dealers tells him how he had overheard Mr. Operator's dealer recommend EgDg to another person. Mr. Small Fry rushes to the dealing room to build a position worth Rs6.67lac (He has a capital of Rs1lac to spare for this). The stock closes for the week at Rs165. There are reports that this stock has also been bought by some mutual funds. In any case, both our friends are happy. The higher closing for the week has ensured that both of them have inflows again due to the higher hawala difference. Mr. Operator has got inflows of Rs44.44lac (Refer Table 1)! Mr. Small Fry, on the other hand, has got an inflow of Rs1.19lac. (Refer table 2)
Table 2 Mr. Small Fry Eg. Ltd. 1999 Mkt. Pr. Org. Cap. Org. Expsoure Marked to Mkt. 14Jun 19Jun 21Jun 26Jun 28Jun 3Jul 140 165 171 180 185 155 100000 100000 100000 100000 100000 100000 666667 666667 666667 666667 666667 666667 -191199 76859 76859 119048 119048 P&L (Hawala Diff.) Add. Exp. His Capital 100000 Net Cash Flow
Add Exp. Total Exp. (Marked to Mkt) 0 0 793651 793651 512392 0 666667 666667 1460317 1460317 1179059 666667
-100000 19048 -100000 -23141 -100000 -291199
June 21st 1999 (Monday): Neuters: EgDg 171 Inspired by the jump in his company's share price, Mr. C.E. Om has called a press conference to announce that his company is unveiling a new molecule. Mr. Operator is even more excited about the prospects of this stock. He has every right to be as the stock price has climbed 70% in 15 days. He deploys the Rs44.44lac that he made from the hawala difference to build an additional position of Rs2.96cr. His overall exposure to EgDG has gone up to Rs4.1cr. Mind you, he has done that with just Rs10lac! (The 'power of leveraging'?!) Mr. Small Fry has also done the same. He has used the profits of the previous week to increase his exposure in the same stock. The stock closes for the week at Rs180. Not a great jump compared with the previous week's figures, but a gain all the same. Anyway, the inflows from the market have dropped for both. Mr. Operator has got just Rs21.59lac (Refer Table 1) while Mr. Small Fry has got Rs76,859. A disappointing week, but how long can the stock just keep going up? June 28th 1999 (Monday): Neuters: EgDg 185 The Investors Guide section of a widely read business paper carried a story on Example Drugs Ltd. They have recommended a 'Buy'. Mr. Sucker, our third friend, reads this on his way to work. Everything falls in place now! He has been watching this stock price climb up, and has not been able to figure out why. The rational investor that he is
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(at least he thinks so) finally finds the reason. He pulls out his mobile phone and calls up his broker to place a buy order. The dealer confirms the trade at Rs185. Mr. Sucker starts thinking of how he will sell this stock at Rs220 on Friday. July 1st 1999 (Thursday): Neuters: EgDg 175 EgDg Ltd. reported its first quarter results. The company has shown flat growth in sales. Profits have dropped... There is chaos in the counter for this stock. Two funds are trying to sell their holdings. Mr. Operator is trying to dump his position. Mr. Small Fry is also caught in between. The stock has crashed all the way to hit the lower circuit. The stock closes for the week at Rs155. For the first time, the hawala difference has turned negative. Mr. Operator has to pay up Rs43.34lac (Refer Table 1). Mr. Small Fry has to pay up Rs1.91lac (Refer Table 2). Our poor friend Mr. Sucker, who had great plans of selling it at Rs220, is left reeling and bewildered. Can you help him? EgDg Ltd. is up 55% since Mr. Operator bought it. But, Mr. Operator has lost money on it at the end of the day. In order to pay up his dues of Rs43.34lac, he will have to sell his original position. Even then, he will not be able to break even. Mr. Small Fry has lost his capital. Can you imagine what will happen on the next trading day when Mr. Operator tries to unwind his position? Our simulation had some simplifications. However, it is a very good snapshot of the way speculative 'booms' and 'busts' happen in the market. It also shows at a collective level how leveraging can turn vicious. Next time, we will see how the imposition of volatility margins by an exchange actually helps and protects people like Mr. Small Fry and Mr. Sucker. After all, our friend Mr. Operator is a smart guy. In reality, he foresees events and creates the top himself. But that is another story.
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Taming of 'Booms' and 'Busts'

Last time we conducted a thought experiment to understand how margin trading enhances the 'boom' and 'bust' scenario. We discovered in the end that even the savvy Mr. Operator could not walk away with profits despite the stock (Remember? Example Drugs Ltd. EgDg Ltd) trading higher than his first purchase price Did something strike you in that example? The most striking thing about the thought experiment was the obvious cascading affect of leveraging when the tide reverses. However, what could have dampened the fall of the market? Let us start with the basics - after all it was all about leveraging, the same old principle that Archimedes spotted. A 15% margin implied that Mr. Small Fry could leverage 6.67 times. In other words, a trader with a capital of Rs1lac can take an exposure worth Rs6.67lac. What if the margin got raised to 30%? In that case, Mr. Small Fry would have been able to take an exposure worth Rs3.33lac instead of the Rs6.67lac. Hence, the sting of a devastating affect of over-leveraging in a falling market would have been removed. Lost a little bit? Let us get back to the example. Last time, we saw how Mr. Small Fry tracked the activities of Mr. Operator and jumped on to the bandwagon. Though he missed the first run from Rs100 to Rs140, he also took the plunge on June 14, 1999. His position appreciated by the end of the settlement as the price appreciated to Rs165. He used the 'havala' cash inflow to take additional exposure the following week. The stock gained the following week too, and our friend increased his position further. We have captured how he increased his exposure in the table below. Of course, for the many of you who ran through it last time, skip it. Table 1
Mr. Small Fry Eg. Dg. Org. Org. Exposure Ltd. Cap. Mkt. Price 140 165 171 180 185 155 1.00 1.00 1.00 1.00 1.00 1.00 (Marked to Mkt.) 6.67 7.86 8.14 8.57 8.81 7.38 -2.34 0.85 1.19 P&L (Havala Diff.)
14Jun-99 19Jun-99 21Jun-99 26Jun-99 28Jun-99 03-Jul99
His Capital 100000 Net Total Addln. Exp. Cash Remarks Exp Flow (Marked to Mkt.) 0.00 0.00 7.94 8.35 5.64 0.00 6.67 7.86 16.08 16.93 14.45 7.38 -1.00 0.19 -1.00 -0.15 -1.00 -3.34 20% 15%
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Final Cash 1.00 Flow (All figures in Rs. Lac)
0.71
-2.34
-0.63
We also saw in the end that the tide reversed, and the stock price fell from Rs185 to Rs155. Mr. Small Fry got caught in the bind. In the end, he had to bridge a negative cash flow of Rs2.34lac. In order to meet this cash deficit, he had to sell his original position. This wiped out his capital and the profit that he still had on his original position. Even then, he had to mobilise Rs63,000 by selling his family gold. Now let us add a twist to the tale. Mr. Regulator has this job of ensuring some semblance of sanity in the market. He polices the market to ensure that there is fair play too. He also exercises control over the prime market leverage - margins! As part of his job, Mr. Regulator had been closely watching the activity in EgDg Ltd. He was getting a little uneasy with the sharp spurt in the share's price - from Rs100 to Rs165 in just two weeks. He realised that this speculation was going a little out of hand. He decided to increase margins to 30% from 15% on June 21, 1999 as the price of EgDg Ltd. ran up sharply to Rs171 from Rs100. He called it the 'volatility margin' as it was meant to curb the unabated speculation. As the frenzy continued unabated, he raised it further to 50% on June 28, 1999. How did it make a difference to Mr. Small Fry? Let us rework the numbers again for Mr. Small Fry Table2
Mr. Small Fry - Additional Margin Eg. Dg. Org. Org. Exposure Ltd. Cap. Mkt. Price (Marked to Mkt.) 6.67 7.86 8.14 8.57 8.81 7.38 0.71 -1.64 -1.64 0.64 1.19 P&L (Havala Diff.)
14140 1.00 Jun-99 19165 1.00 Jun-99 21171 1.00 Jun-99 26180 1.00 Jun-99 28185 1.00 Jun-99 03-Jul155 1.00 99 Final Cash 1.00 Flow (All figures in Rs. Lac)
His Capital 100000 Net Total Addln. Exp. Cash Exp Flow (Marked to Mkt.) 0.00 0.00 3.97 4.18 1.27 0.00 6.67 7.86 12.11 12.75 10.08 7.38 -1.00 0.19 -1.00 -0.36 -1.00 -2.64 -0.08
Addln. Margin
15%
20%
Though the first time Mr. Regulator raised margins, Mr. Small Fry must have cursed him to no ends. But, he must have had better words to use when he actually saw the outcome. Since he was unable to take bigger positions, he did not lose as much when the market dropped. Though he lost his capital in funding the cash flow gap, he was still able to get away unscathed. Remember in the previous instance, he had to sell his family gold to fund the loss of Rs63,000. Hey, wait a minute. Haven't we all seen that the market falls when the margins go up? Why? The market's sentiment takes a beating as traders cannot take those bigger positions that they would like to. Hence, that must have had a dampening affect on prices, in this case, on the price of our good old EgDg Ltd. In other words, the price would not have moved like Rs100-135-140-165-171-180-185 and then fallen all the way to Rs155. Instead, it was likely to have moved more like Rs100-135-140-165-175-176 and then fallen to Rs155. How does Mr. Small Fry fare in such a situation? Table 3
Mr. Small Fry - In Reality Eg. Dg. Org. Org. Exposure Ltd. Cap. Mkt. Price 140 165 171 175 1.00 1.00 1.00 1.00 (Marked to Mkt.) 6.67 7.86 8.14 8.33 1.19 0.00 0.28 P&L (Havala Diff.)
14Jun-99 19Jun-99 21Jun-99 26Jun-99
His Capital 100000 Net Total Addln. Exp. Cash Exp Flow (Marked to Mkt.) 0.00 0.00 3.97 4.06 6.67 7.86 12.11 12.39 -1.00 0.19 -1.00 -0.72
Addln. Margin
15%
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28176 1.00 Jun-99 03-Jul155 1.00 99 Final Cash 1.00 Flow (All figures in Rs. Lac)
8.38 7.38 0.71
0.00 -1.07 -1.07
1.57 0.00
8.95 7.38
-1.00 -2.07 -0.65
20%
Mr. Small Fry takes less of a beating obviously as prices do not rise and fall sharply. In fact, Mr. Small Fry still walks home with more than half his capital intact. We had seen for ourselves how unbridled trading, using leverage, creates 'boom' and 'bust' earlier. This time around, we realised the importance of market regulation. Though Mr. Regulator's actions are scorned by the market, these very actions save the likes of Mr. Small Fry and perhaps prevent Mr. Suckers from getting in. The other key learning is that trading without a proper game-plan can be dangerous. When the market corrects after speculative excesses, it does not even spare the likes of Mr. Operator. Hence, margin trading can prove to be very fatal unless conducted the right way. In a different forum, we will let you know the precautions to be taken to save one's skin while still retaining a chance to profit.
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You know the basics. Now you are eager to know how to make money. Learn the tricks of being a smart investor. Chapter 1: The Nature of the Market Chapter 5: Investing Styles Chapter 2: Understanding Markets Better Chapter 6: Trader's Handbook Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing
Chapter 3
Chapter 3: Investment Strategies

Article 1: Cheap stocks may prove costly | Jun 25 2002 Hey! Love to bite into a cheap stock? Hold on. Cheap stocks are the costliest... Article 2: Invest steadily | Aug 6 2002 You may not catch every peak and bottom but you can get good returns by investing steadily. Article 3: Going Steady, Harem Ishtyle | Jun 24 2000 Steady investments ensure safe returns. But are there times when timing helps? Classic Account SpeedTrade
On the horns of a dilemma: should you time the markets or be a steady investor?
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Investment Strategies Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Cheap stocks may prove costly

How much can you lose? Everything. This is the stockmarket, guys...where it is possible to lose everything. If you entered the market in September 1994, there is a 40% probability that you would have lost everything by September 1999! Don't believe me? Read on... Out of the 3162 companies being traded in September 1994, only 1884 were still trading in September 1999...as many as 1278 scrips had stopped trading (vanished?). Interestingly, 1178 of these companies were trading below Rs50 in September 1994. Share certificates can turn into wastepaper... The picture get gory as you put the lowest Re-price segment of the 1994 era under the microscope. As many as 85 of every 100 sub-Par (shares trading below Rs10) shares turned into wastepaper by September 1999!
This ratio decreases as we move towards higher Re-price stocks. The chart above captures this trend perfectly. As we move from left to right on the graph, the stock prices increase and so do the number of stocks that are still in existence. 69% of all the shares trading between Rs10-20 in September 1994 disappeared from the market by September 1999. Things start looking up somewhat in the Rs20-50 range, with the proportion of 'wastepaper' coming down to 38%. Data Used For this analysis, all the companies which traded on September 30, 1994, have been chosen.

Prices in the month of September 1999 for these companies have been used. The prices of the companies that did not trade even once in September 1999 are assumed as zero. All the stock splits and bonuses have been adjusted.
On the other hand, all stocks above Rs500 survived the bear market that reigned at the Bombay Stock Exchange between 1994-1999. The survival rate was quite high in the Rs100-500 Re-price segment as well, with nearly 95% of the shares alive and kicking in September 1999. Now let's look at the returns An analysis of the returns on investment over this period throws up a similar pattern, which is hardly surprising.
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Returns over September 1994-99
Price Range <= 10 10 to 20 20 to 50 50 to 100 100 to 250 250 to 500 500 +
Positive Return No. of Cos. 17 25 47 33 65 42 16 % 2.34 2.59 9.79 8.68 41.67 26.92 22.54
Negative Return No. of Cos. 710 940 433 347 91 114 55 % 97.66 97.41 90.21 91.32 58.33 73.08 77.46
In case of sub-Par shares, only 17 out of 392 shares provided a positive returns. On the other in 375 (about 96%) companies, investors could not recover even the principal! The scenario worsens in the Rs10-20 category, where only 3% of the stocks gave positive returns. Even shares trading in the Rs20-50 range didn't fare much better-only 5% of them posted positive returns. In comparison, investors who purchased stocks trading between Rs250-500 in September 1994 were better off-27% of these provided positive returns. And nearly 23% of the stocks trading over Rs 500 were in positive territory in September 1999. Low-priced stocks: easy money...or bottomless pit? Mahesh likes the idea of investing in low-priced stocks. His reasoning is simple. He believes that the chances of a Rs10 stock going to Rs40 are higher than that of a Rs500 stock appreciating to Rs2000. So, he feels there's tons of money to be made in low-priced stocks. As he puts it: "Are yaar, Satasat Infotec bahut hi achha lagta hai. 7 rupye ke bhav mein kya khona-downside sirf 7 rupya hai aur upside 100% hai." Guess what? He's right! Our analysis reveals that the sub-Par (i.e. below Rs10) stocks of September 1994 which managed to survive until September 1999 actually delivered the highest returns among all categories!! Methodology
The stocks have divided into 7 categories on the basis of their prices in September 1994, namely sub-10, 10-20. 20-50, 50-100, 100-250, 250-500, and 500+. The percentage existence of the stocks in September 1999 has been calculated on the basis of whether they traded in that month. Percentage returns of all stocks have been calculated over a five-year horizon (September 1994 to September 1999).
Returns of the Survivors
Price Range < = 10 10 To 20 20 To 50 50 To 100 100 To 250 250 To 500 500 +
Overall % Return -70.63 -81.31 -68.04 -64.80 -16.93 -11.31 -11.78
Traded Co. % Return 90.37 -43.61 -48.73 -58.28 -12.45 -8.37 -11.78
But before you jump to any conclusions, look closer. There are only 9 such companies in a list of 392. If Mahesh had picked any of the other 383, he would have lived to regret it. A rupee invested in that category of shares would have shrunk to 30paise in September 1999. Only 2.3% of sub-Rs10 shares doubled in the five-year period, while 85% of them vanished into thin air. Clearly, Mahesh's chances of doubling his money were very low; he was much more likely to have lost all his money. In other words, upside ki baat chodo, poore 7 rupye doob jaate. Suresh's investment strategy is in sharp contrast to Mahesh's-he invests only in stocks that he is fundamentally attracted to. Not due to their rupee prices, but because he finds them attractively valued based on ratios such as P/e. PEG, RONW etc. Let us also assume that most of these companies traded at over Rs100 in 1994. How would he have fared over this 5-year period? Well, Suresh would have also lost money, but he would have been better off than Mahesh. Suresh would have lost a maximum of 17% in the Rs100-250 category as and as low as 11.78% only in the above Rs500 category. One out of every 10 stocks in the Rs100+ segment (or 57 of the 607 stocks) at least doubled over the fiveyear period. On the downside, 24 shares in this list disappeared altogether. Therefore, if he had picked his stocks wisely, Suresh had a better chance of doubling his money.
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You get the drift, right? Well, you'll agree with me now when I say that you can lose everything in the stockmarket. So, what is the best way to avoid to this? That should also be clear after the above analysis. Look for companies with sound fundamentals. And focus on returns-whether the stock has a low Re-price or a high Re-price is immaterial. Let us learn from the past and start channeling our money in the right direction. Happy investing.
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Invest steadily
What would you wish for if an Investment Genie came to you and granted you a wish. No prizes for guessing?You would like to be told when a stock was at a bottom so that you could buy and make a lot of money when it went up. With this knowledge, you reckon, you can make a fortune without the risk of any loss. But then, you are not Aladdin?and do you really believe that the Investment Genie exists? Back to reality my friend. Don?t lose heart. You can still make money in the market. Want to know how? It? s simple actually?Invest steadily! Steady investments need little timing In January 1991, Mr. Orderly developed a habit of investing Rs100 in Hindustan Lever Ltd. (HLL) stock on the 5th, 15th and 25th of every month. By September 1999, his investment amount added up to Rs31,500. He decided to sell his shares on September 30, 1999. The sale netted him Rs170,708. An impressive 441.93% return on his investment. Why 5-15-25? Because Orderly likes the number 5. What if he was obsessed with the number 3 instead? He would then have invested on 3rd, 13th and 23rd of every month. And, surprise! surprise! His returns would have been much the same?444.89% to be exact! There?s a lesson here: If you?re planning to invest steadily, don?t worry too much about the timing. Timing does earn a premium, but it?s not much? Mr. Timer is somewhat of a genius. He has this uncanny ability of identifying the lowest level of any stock during a month (?he?s got it made..?, say friends). Timer also started buying HLL shares worth Rs300 every month starting January 1991. The edge he had over Orderly was that he could pick the stock at its lowest level every month. Timer also sold all his stock (worth Rs31,500) on September 30, 1999. He received Rs180,730. His return? A whopping 473.75%. Impressive! But wait a minute?didn?t that 5-fixated Orderly earn a 441.9% return on the same investment? That means, for all his genius, Timer earned only a 31.8% higher return than Orderly. Considering that we?re talking of returns in excess of 400% here, and that the investment period was over 9 years, it doesn?t sound all that impressive now, does it? ?requires a lot of effort and experience? Mr. Follower is a former employee of Timer. He learnt a lot (he thought so at least!) about the market and identifying the bottoms and peaks of stocks from his boss. In December 1990, Follower felt confident enough to quit his job and start out on his own. He also started buying HLL shares worth Rs300 every month. He applied the rules learnt from Timer to identify the stock?s lowest level for a month. But, the stock market is not governed by a perfect science. Experience plays an important role in successfully applying any rules. Due to his lack of experience, Follower managed to identify the monthly bottoms in HLL for only 6 months in a year. For the other 6 months, he ended up investing at the average monthly price. When he sold his stock on September 30, 1999, he received sum of Rs171,640. His return?457.67%. ?and may not really be worth it
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Follower earned a 15% higher return than Orderly. And for that, he took the pains of following the HLL price movement all the time?trying to identify the monthly bottom levels (and as we read above, he didn?t do a very good job of that anyway!). Compare that to Orderly?s effort. All he did was call up his broker on the 5th, 15th and 25th of every month and ask him to buy HLL shares worth Rs100. Now, was the 15% higher return earned by Follower really worth the effort? Tomorrow never comes Mr. Waiter is not really an investor (though he does have pretensions). He spends 5 minutes every morning pouring over the market pages in the newspaper and noting down the stock prices. He wants to wait for the stock prices to fall to a bottom before buying. With this kind of mindset, more often than not he never actually buys a stock.?all money-making opportunities pass him by. How our investors rank
Orderly Investment Strategy Return on Investment Time involved Effort involved Steady Investment on 5th, 15th, 25th 441.93 Minimal Low
Follower Waiter Same as Martin Always waits Investment at but with lower for lower lowest Index level success level Index 473.75 A lot of time High 457.67 Even more time High ? Does it matter? Way too much
Timer
Year-wise Returns on Investment
Period
Closing 171 365 550 590 624 808 1366 1681 2585
Jan'91-Dec'91 Jan'91-Dec'92 Jan'91-Dec'93 Jan'91-Dec'94 Jan'91-Dec'95 Jan'91-Dec'96 Jan'91-Dec'97 Jan'91-Dec'98 Jan'91-Sep'99
Price Return on Investment Timer Orderly Follower 14.96 8.92 13.55 86.14 74.64 80.75 134.79 120.71 128.28 111.57 99.31 105.61 100.91 89.74 95.47 135.11 122.27 128.79 258.89 238.90 248.79 300.43 278.20 289.22 473.75 441.93 457.67
There is no real cause for concern if your investment philosophy matches that of Orderly or Timer (or even Follower, for that matter). As long as you pick the right stocks, you will end up making money. But if Mr. Waiter reminds you of yourself?now, that is an ominous sign. It?s time to wake up. If you need guidance, look no further than this very issue of ?Taking Stock?. Scrips like Infosys, HLL, Wipro, Indian Shaving, Pfizer & Dr Reddy beckon. You don?t need an Investment Genie. And you may not be able to identify the bottoms and peaks?but you? ll make money anyway. Happy investing!
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Going Steady, Harem Ishtyle

Last session, we learnt that timing is not a key factor for making money in the stock market. Sure, the returns do go up when you time as well as Mr. Timer. But then you need to be quite a genius, to be able to time as well as him. If not, I am afraid that it requires a lot of time and effort and even then there are no guarantees that you will be as successful as Mr. Timer. It?s very likely that you might get left out like Mr. Waiter. The key to returns in this market is steady investment. This week we dig deeper into this issue. Let? s see what we unearth. In defense of timing Many of you who are in the business of timing the market might not have appreciated our analysis (of course, being told that they earned only 31.8% more than the steady investors in HLL over a 9-year period hasn?t exactly endeared us to them!). They argue that HLL is the wrong example to use for this argument. The extra returns earned by HLL are not high because the stock?s long-term trend has been in the upward direction, they contend. They believe that the premium earned through timing is far higher for stocks that have not been in a secular uptrend (which are more range-bound). Is there any truth in this contention? To find out, let?s consider a big cyclical company?Reliance Industries Limited (RIL)?and rework the investment returns of Mr. Timer and Mr. Orderly. How different are returns on a cyclical stock? As you read last week, Mr.Orderly had invested Rs100 in HLL stock on the 5th, 15th and 25th of every month since January 1991. Let?s assume that he had invested in Reliance instead. Then, on selling all his stock (worth Rs31,500) on September 30, 1999, he would have received Rs63,216. His return on investment?100.69%. Assume also that Mr.Timer, that old master at finding the bottoms, started investing Rs300 in RIL every month beginning January 1991. By selling the RIL shares on September 30, 1999, he would have earned a return of 120.89%. So there you have it. While steady investment in RIL over the Jan1991-Sep1999 period yielded a return of 100.69%, timing the investment earned an extra 20.2%. Mr. Timer did fare better with Reliance Over the nine-year period, Mr.Timer earned 20.2% more than Orderly on the same investment. The figure does substantiate Mr.Timer?s argument that the premium derived from timing a stock is higher for rangebound stocks as compared to stocks like HLL, which show a long-term uptrend. If you remember, on HLL, Mr.Timer made a return of 473.75% over the 9-year period while Mr.Orderly earned 441.93%. In other words he earned an extra 31.82% for his efforts, a measly premium of just 6.7%. On RIL, on the other hand, Timer has earned a premium of nearly 20% as compared to Mr.Orderly?s returns. So -Yes, Mr.Timer did do much better with Reliance than with HLL What if they take exposure to both HLL & RIL? No investor keeps all his eggs in one basket. Diversification is the best ?mantra? of any prudent investor. So, let?s create a portfolio consisting of both HLL and Reliance.
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Let?s assume again that Orderly invested Rs100 on 5th, 15th and 25th of every month starting January 1991, but that he spread his investment over two stocks?Rs50 in HLL and Rs50 in RIL. On selling his stocks on September 30, 1999, Orderly would have received Rs125,527 this time around?an impressive 298.50% return on his investment. Now let?s see how Timer would have fared in this scenario. He would have invested Rs300 per month in an equally weighted portfolio of HLL and RIL over the same period, the difference being that he would?ve identified the bottom levels of both stocks every month. His investment would?ve earned him a return of 321.55%. What does that mean? Well, the bottomline is that Timer, for all his expertise in timing, ends up earning a premium of just 7.87% over Orderly?s returns. A measly 7.87% for all that effort! How do things change in a diversified portfolio? Obviously, in real life any long-time investor can be expected to have at least 10-12 stocks in his portfolio. For the purpose of diversification, let?s assume that these 10-12 stocks will be of different kinds. Some would be like HLL, an Evergreen stock, and some would be cyclicals like Zuari where there is much more money to be made by timing. In other words, the contribution of timing in such a portfolio would be somewhere in between the two extremes, perhaps to the tune of the premium earned by Mr.Follower (remember him?). In a good and managed portfolio, however, the timing factor gets marginalised. In such a portfolio, the returns earned by Orderly are likely to beaten by only the slimmest of margins by Timer. And in real life, because we often fail to catch the bottom (like Follower), there is a big risk that we could end up with money in our bank (like Waiter) even as the stocks we want continue to gallop higher. The key to making money in the market with the least amount of effort involves just two simple steps. First, and the most important, is steady investment. The other is investing in a portfolio. By following these two steps, you will not only make money but your returns could even match those of Mr. Timer. Happy investing!
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You know the basics. Now you are eager to know how to make money. Learn the tricks of being a smart investor. Chapter 1: The Nature of the Market Chapter 5: Investing Styles Chapter 2: Understanding Chapter 3: Investment Markets Strategies Better Chapter 6: Trader's Handbook Chapter 7: Futures and Options Chapter 10: Psychology of Investing
Chapter 4
Beyond PEs & PEGs- climbing the ropes of equity valuation. Article 1: Of cash flow discounting | Sep 24 2002 Making the best investment decision based on cash flow discounting. Article 2: Return on net worth | Aug 23 2002 Why has the market given a premium to HLL compared to Colgate? Well, it has to do with the RoNW... Article 3: Cost of Equity -- it's for real | Oct 6 2000 You think cost of equity is cheap? Think again... Article 4: Getting to know RoCE | Oct 8 2002 Meet the crown jewel among valuation ratios: Return on Capital Employed. Article 5: Economic Value Added | Nov 13 2000 The cream that every investor should look for. Article 6: It takes two to tango | Oct 11 2002 To understand the story missed out by P/E, let's meet EV and EBIDTA.
Chapter 4: More on Valuing equities
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Article 7: The missing link | Oct 14 2002 Why do a few good stocks consistently trade at a premium to their fair value? Article 8: Real options at work | Oct 18 2002 It is time to start learning to value the unimaginable that is valuable in stocks. Article 9: Return on assets | Oct 1 2002 This sibling of RoNW and RoCE steps in at a time when the other two can't be relied on. Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page More on Valuing equities Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Of cash flow discounting

Here is a small recap for all of you who have missed our earlier school articles on investing and time value of money. Investment is essentially a matter of putting your savings into an asset (bank deposit, bonds, debentures, shares, real estate etc) with the expectation of receiving a larger sum in the future. Since the future is not certain there is risk in the investment for which investors will wish compensation through time value of money. That makes intuitive sense, doesn't it? Lets try a small quiz. If you invest today, a sum of Rs.100 in a post office at the rate of 10% compounded annually for 2 years then how much cash you will receive after two years? What? You said very simple! And your answer is Rs. 121. Brilliant! Now, lets try a tricky one. If the same post office promises you to pay Rs.121 two years from today and the rate of interest is same at 10% compounded annually then how much money he will ask you to deposit? Yes, you got it - it is the same Rs. 100. But let us check the science behind it. As you know, Rs.100 today is worth more than Rs. 100 tomorrow, because of the inflation and the investment risk i.e. the risk you take in investing this Rs.100. This is called the "Time Value of Money" In our example above, Rs. 100 that you deposited in the post office is your principal investment. The interest rate of 10% is the "time value of money". When you answered Rs.121 as the money you will receive after 2 years, you added the time value of money to your original investment. But when you know the amount (cash flow) you will receive after two years then you need to remove this time value of money from that amount to get the fair price, also known as present value, you should invest. This method of finding the present value is known as Cash Flow Discounting and the time value of money is called the discount factor. Cash flow discounting is the backbone of all financial analysis. Why? All project decisions are based on the cash flow discounting. As a matter of fact, this cash flow discounting is the prerequisite that must be used in the decision of every penny spent by a corporate. For a corporate, the time value of money is the cost of their capital (a topic that we can discuss in detail some other time). Now lets check how a corporate uses this concept in its decision making process with a simple example. Should we upgrade the computer? A large manufacturing firm is considering improving its computer facility. The firm currently has a computer that can be upgraded at a cost of Rs20000. The upgraded computer will be useful for 5 years and will provide cost savings of Rs7500 per year. The cost of capital (time value of money) is 15%. Should the company spend Rs20000 in upgrading the computer? If the company decides to upgrade, it will save Rs7500 every year for next five years. But the money has to be paid today, so the company must decide today whether it makes financial sense. So it needs to find what the saving is worth today - i.e. what is the sum of the present value of these savings in each year. Does that sound complicated? How it will do it? Just apply the above science of Discounting Cash Flow. Saving in year 1 (Rs. 7500) will be discounted by one year discounting factor,
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saving in year 2 by two years discounting factor and so on.
Present Value of saving in year 1 = 7500* 1/(1+0.15) = Rs6522 Present Value of saving in year 2 = 7500* 1/(1+0.15)2 = Rs5671
discount factor discount factor
Similarly, you can calculate for third year as Rs4931, fourth year as Rs4288 and fifth year as Rs3728. By adding the present value of all these savings you can get the present value of the total saving by computer upgradation in five years as Rs25140. The total cost of the proposed project is Rs20000. Hence the company can save a net of Rs5140 by undertaking the upgradation. This net value of saving is known as the Net Present Value (NPV). So here is the conclusion from the example. If the NPV of the project is positive then go ahead with the project and vice versa. (and if companies go ahead with a project with a negative NPV - well, what can we say -that is throwing good money after bad!) The story of project selection does not end here. When a corporate makes an investment decision, it may have an array of options or projects that they can undertake. As a simplistic example, if Reliance were to decide to spend Rs 200 Cr in increasing their polyester fibre capacity, they may compare it to acquiring an existing unit, or even with an altogether different project such as spending the money in the refinery or the jetty or a telecom project instead. . For all the options, the corporate will project the future cash flows and then calculate the net present value. One of the key tools in the selection of the project would be the one that yields the highest NPV. But this is how companies take decisions. How you I use this NPV as an investor? As an investor, you can use this discounted cash flow analysis for comparing the investment opportunities and selecting the better one. You decide your investment horizon, and calculate the possible cash flows from different investment options within that period of time. The option with the highest NPV represents the best investment worthy option.
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Return on net worth

What's the first thing you look for when you need to put your savings away in a fixed deposit in a bank? Returns? Bullseye! If you have put Rs100 in the fixed deposit in and have Rs110 in your account at the end of the year, your return is Rs10. This extra Rs10 is what induces you to save. What about your investment in the stock of a company? Remember, investing is like owning a business. You should ask how much return the company makes on its capital. After all, the higher the return, the more money you earn on your investment. How do you measure returns? Before going into how returns are measured, we need to know what we, as shareholders, have at stake in a company... Net worth is funds that the shareholders own - their equity. It represents the capital contributed by the shareholders and the accumulated net profits after paying out dividends (retained earnings). This is what belongs to the shareholders and is re-invested into the business. Dividends are excluded from capital because they entail a cash outflow for the company, and this amount is not re-invested into the business. And how do you measure the returns earned? Return on Net Worth (RoNW) is defined as Net Profit divided by Net Worth. Simply put, it shows the returns that the shareholders have earned on their funds utilised in the business. Do you still wonder why RoNW is a favourite return ratio with shareholders? It examines earnings in relation to capital. The stock market is dotted with countless instances where high return companies have yielded higher stock returns. Taking the example of Hindustan Lever vs. Colgate...
HLL (Rs in crores) RoNW (NPM 'turnover' leverage) Incremental RoNW Stock Returns Colgate (Rs in crores) RoNW (NPM 'turnover' leverage) Incremental RoNW Stock Returns
1999 51% 7% 35% 2000 17% 11% 7%
1998 48% 7% 20% 1999 16% -43% -24%
1997 44% 20% 71% 1998 27% -11% 9%
1996 37% 1997 31% -
Hindustan Lever has consistently earned better returns on shareholders' funds than Colgate. Thus investors find it a more lucrative deal to invest their money in HLL than in Colgate. This ultimately reflects in the companies' stock prices. HLL's stock has turned in much higher returns than Colgate's, over the same time frame. So where has HLL scored over Colgate? After all, both these companies have similar business profiles. They cater to a similar class of consumers. Both of them boast of MNC parents. And they both have strong brands in the country.
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The answer to this lies within the Return on Net Worth ratio itself. Dig deeper and this ratio offers a good perspective on the business and a company's prowess in conducting it. We probe into the RoNW ratio using a little arithmetic...
Return on Net Worth = PAT / Net Worth = (PAT/Sales) x (Sales/Assets) x (Assets/Net Worth) = (profitability) x (efficiency) x (leverage)
Merely splitting the basic ratio into its various possible components reveals a treasure of information and insight that it can provide on a company's operations. For the RoNW to be higher, a business has to score on three crucial aspects - profitability, efficiency and leverage. Now if we break up the RoNW of both HLL and Colgate into these three components, this is what we get.
HLL Net profit margin (NPM) Sales/ Total Assets (turnover) Total Assets/Net growth (leverage) RoNW (NPM* turnover*leverage)
1999 10% 4.78 1.08 51%
1998 8% 5.21 1.16 48%
1997 7% 5.75 1.15 44%
1996 6% 5.17 1.23 37%
Colgate Net profit margin (NPM) Sales/ Total Assets (turnover) Total Assets/Net growth (leverage) RoNW (NPM* turnover*leverage)
2000 5% 3.65 1.02 17%
1999 5% 3.34 1.02 16%
1998 8% 3.42 1.02 27%
1997 8% 3.66 1.02 31%
Profitability Do we really need to state the importance of profitability in a business? Profitability reflects whether a company is able to sell its goods and services competitively in the market. That's where the power of brands, distribution, pricing, etc. of the companies come in. Hindustan Lever has an Operating Profit Margin (OPM) of 15% while Colgate has an OPM of about 10%. This despite Colgate having the strongest presence (so far) in a niche segment. Higher profitability contributes to better returns. Efficiency in the use of capital Put simply, an efficiency ratio is indicative of how hard the company has put its assets to work. The assets must translate into sales. After all isn't that the very idea in installing the asset? Hindustan Lever generates far higher sales on its assets than Colgate does. At this juncture, it is important to point out that the issue of efficient use of assets assumes a lot more importance for capital intensive companies. They often lose out on this parameter and have to contend with poor returns. Take the instance of Reliance Petroleum, which has set up a world class refinery at a cost of over Rs14,000cr. Fair enough. But the shareholder isn't interested in setting up a plant - world class or otherwise. What matters to him is the revenue stream that can be generated by the asset built at such a huge cost. What happens if the plant does not operate at its capacity? No sales are generated but the company anyway has to pay interest worth Rs960cr and depreciation worth Rs687cr on the assets annually. It does not require advanced calculus to figure out that returns would definitely suffer. Leverage While competent operations hold the key to better returns, the mode of financing the operations and assets has a bearing on returns too. As we discussed previously, there is a fair amount of science involved in choosing the appropriate mode and mix of financing. A higher component of debt in the capital structure normally results in higher returns. This is called the impact of leverage. Colgate and HLL are on a similar plane on this parameter. Taking stock... Returns reflect the level of profitability, efficiency and the impact of leverage. A company that has been able to deftly score on all these parameters enjoys the best returns. The stock market isn't blind to returns. There is a distinct positive correlation between incremental Return on Net Worth and the returns on the stock, as is evident from the first table. Stating what should seem very obvious by now, the higher the return, the better. But how high a return is high enough? On the higher side, there is no limit to how high a return can be or ought to be!
But on the lower side, there is a threshold level of return that the company must earn. And that is the `risk premium'.
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The crucial difference between savings and investments is 'risk'. When you decide to invest, savings assume the form of risk capital. Having said that, risk is a matter of choice, and there is a leveller called the risk premium that balances the deal for investors. The returns generated by the company should at least compensate for the additional risk that you are taking by investing in the company. Returns: what they do not tell us? Return by itself tells only part of the story - the happy part. There is a vital something that is missed out, and that is the concept of 'cost of capital'. Any business has to pay for the use of capital and returns do not account for this cost. At the end of the day, what finally accrues to the business is the return less the cost of capital. That brings us to the concept of 'economic value added', which is nothing but returns minus cost of capital - and is a fair representation of what is finally and ultimately gained (the 'take home' as the common man understands it) from the business during a given period. The higher the economic value added, the more valuable the company. But that's another episode by itself...
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Cost of Equity -- it's for real

" ...we prefer equity to debt as it works out cheaper for us..." -promoter of a company that raised money in the 94 IPO boom
Nothing could be further from the truth. It's true that, unlike debt, there is no fixed cash flow that a firm must compulsorily give to its shareholders on a regular basis. But that in no way means that equity is cheap. In fact, equity has a cost and the cost is real. Dividends and its offshoots Dividend payout is the most visible cost, as it represents a company's cash outflow to shareholders every year. By the way, dividend is defined as the distribution of earnings to shareholders during a year. For a minute, let us assume it is dividend that is cost of equity A company normally announces dividend as a percentage of the face value of its share. Hence, when HLL says it is paying a dividend of 290%, it actually means that it is paying a dividend of Rs2.9 per share (remember the face value of HLL is Re1 now)! But don't we pay Rs215 to buy a share of HLL? So we earn Rs2.9 on Rs215 that we invest! That works out to 1.35%. Incidentally, this is called 'dividend yield' What? For bearing all the risks associated with equities we get less than a savings bank deposit return? Are we missing something? Of course we are... A few steps back before we take the big leap forward Right at the beginning, we discovered that the investor has his eye on the big stakes. He is willing to risk his capital today in an investment that he believes will earn him returns over the life of the business. He believes that in future such an investment will yield much superior returns to that of a debt investment. Hence, the price of the stock at any given point in time is the value that is placed on the expected future stream of dividends from the business over its lifetime. So when you sell a stock you are effectively selling the right to future dividends that you could have earned from the stock. Now, does current dividend indicate future dividend flows? No. This is because dividends in future are expected dividends. The actual dividends might be higher or lower, depending on profits for that year and the profits the company wishes to plough back into its business to earn higher profits in future years. A small aside -- the proportion of profits that a company pays out in a given year is called 'dividend payout ratio'. And the proportion of net profit that it ploughs back into business is its plough-back ratio. Since HLL paid out Rs638cr as dividend out of its profits of Rs1070cr in FY2000, its dividend payout ratio was 60%. So as the company grows in size, enhancing its ability to earn more profits and pay higher dividends in the future, the value that the market places on the future dividend stream increases. In other words, the market price increases. We all know this as 'capital gains'. We know that we buy stocks for capital gains but, in essence, we still invest in stocks for the future dividend stream that is captured by the 'capital gains'.
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In short, stocks are bought for their dividend yield and their capital gains. Thus, the expected rate of return from equity is: Expected rate of return = dividend yield + capital gains Since this is what shareholders expect from their investment, a company has to deliver on these counts in order to service its equity. This is its cost of equity. At this stage, we could take a break to ponder over an age-old wisdom -- Isn't 'A bird in the hand is worth two in the bush'? Is the present dividend (which is safe) always preferable to future dividends (which are risky)? Reliance Industries (has a dividend payout ratio of 17%) has a good track record of paying dividends. Infosys, on the other hand, pays out only 10% of its net profit as dividend. Its dividend payout is 10% and plough-back ratio is 90%. Infosys is held in higher esteem by the market. Why? Infosys has a return on net worth (RoNW) of 42%. Its net profit is growing at over 80% year on year. If instead of paying out this profit as dividend, the company re-invests a substantial portion back into its business, then this capital could earn an additional return next year. For instance, in FY2000, Infosys ploughed back Rs264cr (that's 90% of its net profit) into its business. This will earn an additional return of about Rs110cr (simply 42%*264) this year even if the company maintains its RoNW. Thus, on this count alone the re-invested amount will yield a growth of 38% (simply the plough back ratio * RoNW or 90%*42%) in its earnings. Now let us work out similar numbers for Reliance. Reliance has a RoNW of 23%. It re-invested 83% of the net profit, that is Rs1983cr, in FY2000, into its business. Therefore, this incremental amount can generate a return of Rs464cr, implying a growth of about 19%. Thus a Rs100 re-invested in Infosys will compound at the rate of 38% while that in Reliance will compound at the rate of 19%. According to finance gurus, Brealy and Myers, "This is because the reduction in value caused by reduction in dividends in the earlier years is compensated by the increase in value caused by the extra dividends in later years." Simply, investors in such high-growth firms are willing to forgo dividends in the early years in the hope of enjoying much higher dividends in future years. As a result of this the stock prices rise. In other words, shareholders are indifferent, so long as a lower dividend yield is compensated for by a higher capital gain. But how do you calculate cost of equity? Familiar path that we treaded while discussing "Risk Premium" So Capital Asset Pricing Model (CAPM) must be the answer. Thus the cost of equity, ke = Rf + beta (Rm-Rf) Where ke = cost of equity, Rf = the risk-free premium, Rm = market return. If we plug in the values for HLL in the above formula, its cost of equity works out to 21.9%. So the next time someone tells you that equity is cheap, you know better! A company should earn a return on equity that is at least greater than the cost of its equity. Thus, cost of equity sets an important standard to evaluate the way a company does its business.
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Getting to know RoCE

Assume that a genie appears before you for some bizarre reason. And he wishes to grant you a boon -- just one financial ratio as a valuation tool. What would you ask for? Would it not be the ratio that will help you figure out in one go general management performance in relation to the capital invested in the business? Well, what you would be asking for is good old Return on Capital Employed! While valuing companies, we are actually trying to measure the return that the company is able to generate. Those companies that earn a higher return on every rupee that is invested are more valuable than those who earn a lower return on a similar investment. Two very popular tools that come in handy in studying returns generated by companies are: 1. Return on Net Worth, defined as Net Profit/Net Worth. 2. Return on Capital Employed, defined as Operating Profit less Depreciation/(Net Worth + Debt - Non Interest Bearing Debt). The next question that presents itself is: How are they different? And, more importantly, which is a better measure of return? Well, let us hear the sales pitch of both of them. Enter Return on Net Worth We have met Return on Net Worth before. In all its simplicity it tells us what, as shareholders, we are getting back from our investment in the business. And as a shareholder that is what you are interested in. Enter Return on Capital Employed Is shareholders' equity the only funds that the company uses during the course of its business? Of course not. The company could raise money - and often does - from other sources too, like debt, preference shares, warrants etc. Some even use lease financing. Return on Capital Employed does not discriminate between different types of capital. It compares operating profit (less depreciation) against the total capital employed in the business. Thus it works at a more basic level. It reflects the overall earnings capacity of the business. A small aside: Why does the RoCE take operating profit after depreciation? This is because although depreciation is a non-cash expenditure, it is a payment towards the use of assets. At a slightly conceptual level, depreciation is the amount that a company sets aside to replace its assets in future. After all, every asset has a life and needs to be replaced sometime. Thus depreciation is a real cost of production and must be deducted from the operating profit. Now that we have heard what each of them had to say...But before we get into the verdict let us take two examples.
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Here is a company, Efficient Ltd. It's business is doing well and it manages to rake in a neat margin of 35% at its operating level. At the end of the year, here's how its numbers look in three diverse debt-equity scenarios.
Efficient Ltd. Equity Debt Sales Operating profit Depreciation Interest PBT Tax PAT RoNW RoCE
Scene1 30 70 100 35 10 11 14 5 9 29.9% 25.0%
Scene 2 50 50 100 35 10 8 17 6 11 22.1% 25.0%
Scene 3 70 30 100 35 10 5 20 7 13 18.8% 25.0%
Reflected in these three scenarios above are three different financing patterns. In Scene 1, the company has funded 70% of its business from debt while at the other extreme, Scene 3, 70% of the capital is equity. A company might fund its operations with debt or equity or varying combinations of both. In Scene 1, the high leverage has maximised returns to Efficient Ltd's shareholders, that is it has maximised RoNW. A caveat - as we discovered earlier, although debt enhances returns to shareholders, it also increases the riskiness of the company (we'll discuss this a little later). RoCE, on the other hand, is indifferent to the mode of financing. It remains the same across all three leveraging scenarios. Thus RoCE misses out on the crucial aspect of financing pattern. But before you cast your vote in favour of RoNW, here is the other example There are two companies operating in the same business - Strong Ltd. and Not-so-strong Ltd. And here is a glimpse of their financials.
. Equity Debt Sales Operating profit Depreciation Interest PBT Tax PAT RoNW RoCE
Not-so-strong Ltd. 100 50 100 54 15 8 31 11 20 20.0% 25.9%
Strong Ltd. 150 0 100 61 15 0 46 16 30 20.0% 30.8%
Lo! Both companies have a RoNW of 20%. Now which would you choose? As a shareholder, should you be indifferent to both? Hmm ...a dilemma? But look once again at the numbers. Strong Ltd. has funded its entire business from equity while Not-so-strong Ltd. has funded about onethird of its business from debt. Now, to belabour the point, debt adds to the Return to Net Worth but it also adds to the company's risk, since it entails a fixed obligation by way of interest. So in bad times, debt wears heavy on the company. If two companies have the same RoNW, then, strictly speaking, the company having lesser debt is better, all other things being unchanged. It has lower fixed liabilities and less risk. If you look closer, you will see that Strong Ltd. earns higher operating margins than Not-so-strong Ltd. Thus, operationally, Not-so-strong Ltd. is inferior to Strong Ltd. Then how come it has the same RoNW as Strong Ltd.? You know the answer - in good times, leverage adds to returns. But the RoCE is very sensitive to operational strength. It is quick to spot anomalies in operations. While Not-so-Strong Ltd. has a RoCE of 25.9%, Strong Ltd. enjoys a much higher RoCE of 30.8%. If we really want to gauge the efficiency of a company's operations, then the returns should be seen in relation to the total capital employed - whatever its form may be. What difference does it make if the funding has come in from equity or debt, so far as operations are concerned? The verdict... a draw! RoNW gives us the final picture of how a business is performing. To that extent, RoNW is a good indicator of how much you are getting on your investment in capital. But do not stop at testing just how much your capital (shareholder's funds) has
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returned to you. You must also test if your capital is safe. There are plenty of instances when companies heavy with debt have eroded their net worth over a period of time. Thus, RoCE is a better measure to test the viability of the company's operations; RoNW is better to gauge the returns that you get as a shareholder. In order to get a complete picture of a company's ability to generate returns, one needs to keep track of both these ratios - Return on Capital Employed and Return on Net Worth.
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Economic Value Added

You may recall seeing Economic Value Added Statements in many annual reports - Infosys (for that matter in those of most software companies), Hindustan Lever and even Balrampur Chini to name a few. EVA as a tool for spotting value has assumed a lot of importance these days. But what exactly is this new thing, EVA? And is it important for you as a shareholder? Very simply, EVA is a measure of value that a company has added as a result of its operations during a period of time. And it has its genesis in the same timeless concepts of RoCE and Cost of Equity. Return on Capital Employed, we saw, is smart in showing the operational competence (or lack of it) for a company. But it still does not indicate the "take home" that you get by investing in the business. This is because something very crucial is still to be accounted for and that is the Cost of Capital. Cost of Capital? A business makes use of capital for its operations. And capital - debt or equity - entails certain costs. For a company, the overall cost of capital is the sum of cost of debt and cost of equity weighted by their proportion in the total capital. This is called the Weighted Average Cost of Capital (WACC). Now, Cost of Capital sets an important benchmark for the company. This is the least return that it should earn on its capital for its operations to make sense in the first place. If the RoCE is equal to the WACC, then it effectively means that the company is worth the initial investment, since it has earned exactly what it has paid for its capital. It's a 'nothing lost, nothing gained' scenario - that is, it's a kind of break-even for the shareholders. Anything that the firm earns over and above its cost of capital is what has been added by way of value from its operations. This simple concept is called Economic Value Added. Thus,
Economic Value Added
Return on Capital Employed

-
Weighted Average Cost of Capital
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Ultimately, this spread between the RoCE and the WACC is what the market seeks and values in a company. This is the very source of capital appreciation. In fact, this is what you are betting on when you are taking a risk on an equity. The concept of EVA is not new Needless to say, EVA has its relevance in any and every business. And that's the reason for its universal popularity. But while EVA has become a much talked about parameter, it is not as if it is a novel concept hit upon only in recent times. This concept of a business's ability to earn something over and above what it pays for its capital has been in existence for a long time. Way back in 1890, Sir Alfred Marshall, while defining the concept of economic profit, had said, "What remains of his (owner's or manager's) profit, after deducting interest on his capital at the current rate, may be called the earnings of his undertaking." The EVA way of determining value EVA is just another way of determining value rather than a new concept in itself. To get a perspective on the EVA way of calculating value, take the example of Hindustan Lever. 1. The first step is to calculate the Return on Capital Employed, tax adjusted. Net operating profit less adjusted taxes divided by the average Capital Employed gives the Return on Capital Employed. Aside: Why deduct taxes? This is because, as a shareholder, you are entitled to what is ultimately due to you after paying all possible expenses. And tax is a statutory payment that needs to be paid anyway. Thus for the calculation of RoCE for EVA, we take the operating profit less tax.
Calculation of ROCE Operation Profit - Less Depreciation - Less Tax Paid - Less Tax shield on interest Net Optg Profit less adj Taxes (NOPLAT) Average Capital Employed RoCE(%)
(Wondering what Interest Tax Shield is?)
1999 1,206 129 318 5 754 2,118 36
1998 956 101 286 8 562 1,703 33
1997 711 58 281 11 361 1,412 26
1996 464 55 173 17 219 688 32
2. The next step is the computation of the Weighted Average Cost of Capital. Well, its name is self-explanatory. All we do is calculate the cost of debt (using interest), cost of equity (using CAPM), and the proportion of debt and equity in the total capital employed. And, finally, compute their weighted average cost.
Calculation of WACC Cost of debt(adjust for tax) (%) Weight of debt in total capital (%) Beta Cost of equity (%) Weight of equity in total capital (%) WACC (%)
3. Finally, tax adjusted RoCE minus WACC gives EVA.
1999 8 8 0.8 20 92 19
1998 10 14 0.8 20 86 18
1997 10 13 0.8 20 87 19
1996 31 19 0.8 20 81 22
Calculation of EVA RoCE (%) WACC (%) EVA (%)

Voila! - we have EVA!
1999 36 19 17
1998 33 18 15
1997 26 19 7
1996 32 22 10
As is evident, the primary strength of EVA is that it helps to track the value added by a company year
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after year. If you just ponder about EVA, you would realise that it is no different from discounted cash flows so far its principle goes. EVA and DCF - siblings EVA does something similar to what discounted cash flow (DCF) does. It takes the returns from operations and deducts all charges of operations, including depreciation, and then finally deducts the cost of capital. And that is what the company has earned for the year. And what does a DCF do? It finds the free cash flows of the firm over its life after deducting all charges towards operations and financing. Isn't then EVA akin to free cash flow? It is! Now the Net Present Value of these free cash flows (in DCF) give the fair value of the company today. Similarly, can we compute the fair value of a company using EVA? Hmmm... true that EVA is often expressed as a percentage, since both RoCE and WACC are computed as percentage of capital employed. But instead of taking EVA as a percentage, if we just take the operating profit minus taxes and deduct the capital charges, then the resultant is the amount of value added in absolute terms (in crores in this instance). When the stream of EVA over all future years in the life of a company is discounted to the present, then the cumulative EVA will be nothing but equal to the Net Present Value. But what has spurred the popularity of EVA over DCF is that it is a more practical version. It can be calculated for every period and hence is the more handy tool to track the performance of a company.
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It takes two to tango

PE, BV, EV, RC - these alphabets keep popping up in discussions about stocks and stock markets. If you do not feel at home in the maze of these alphabets and acronyms, then you might want to take a look at an earlier discussion - "BV, EV aur RC: The Alphabet Soup of Valuation". This discussion is devoted to the concept of enterprise value (EV) and how it helps in valuing companies. Enterprise value does just what its name suggests that it does - it seeks to find the market value of the enterprise
J. Simple isn't it?
But remember that the operative word here is 'market'. The enterprise value at any instant of time tells us the value of the firm as the market sees it. It does not say if that is the fair value of the company nor does it concern itself with the balance sheet value of the company. It says if you were to buy over the company what would you need to pay today. You will need to buy all its equity at its market price. Also since you are buying over the company, you assume the responsibility for all its debt. And finally, the company has some cash and investments that you inherit, and your cash outflow stands reduced by that amount. Thus the Enterprise Value is market value of equity plus market value of debt minus cash and investments. The market value of equity is the current market price of a share multiplied by the number of shares outstanding. This is nothing but market capitalisation. It goes without saying that the market value of equity is what undergoes a continuous change with the change in prices. And due to this component, the enterprise value changes continuously. As for debt, normally, the value does not change. Mind you, during periods of inflation, the value of debt instruments may fluctuate wildly. For firms, however, much of the debt consists of term loans that are unlisted and hence the value does not undergo much change. It is quite fine to take it as shown in the company's books.
Thus Enterprise Value
= + -
Market Capitalisation Debt cash and investments
What if the company does not have debt, like most software companies? Then the enterprise value is equal to the market capitalisation... Take a look at Table 1 -
(Rs cr)
Equity No.of shares (cr)
Infosys 33 6.6 47692 0
Satyam
56 28.1 9730 291
Mkt Cap
Add Debt
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Less Cash plus Investment Enterprise Value
446 47529
163 10021
The enterprise value for Infosys, for example, is Rs47529cr. This is higher than the balance sheet value, which is Rs2,689cr. Also, the EV is by no means the fair value. The fair value, which can be calculated using the discounted cash flow model - may be lower or higher. Now that we know the enterprise value of Infosys is Rs47529cr, what do we do with it? Enterprise value cannot be interpreted on a stand-alone basis. Just as price or market capitalisation cannot be interpreted by themselves. To make sense out of a company's stock price, we compare it against the earnings per share or the book value per share our very own P/E and P/BV. Generically speaking, we are comparing a market variable with an operating variable. A good measure while valuing companies is to evaluate the enterprise value in relation to the EBIDTA. EBIDTA? EBIDTA stands for 'Earnings Before Interest, Depreciation, Tax and Amortisation'. It is the total income that a company has generated from its operations minus its operating expenses. EBIDTA is also known as the operating profit. Instead of 'earnings', some people prefer the word 'profit' and hence EBIDTA is also referred to as PBIDTA. "What's in a name!" as Shakespeare would say. Table 2 shows the position of EBIDTA in a typical Profit and Loss Statement...
(Rs cr)
Sales Operating Expenses EBIDTA Interest (I) Depreciation (D) Tax (T) Extra Ordinary Items Profit After Tax Amortisation (A) Wondering what's amortisation?
Infosys 921 543 379 0 53 40 8 294 0
Satyam
679 426 253 41 71 6 5 140 0
Voila! We have EV and we have EBIDTA. EV tells us the market value of the company. EBIDTA tells us the operating profit of the company. Just pause and reflect what they both together tell us.... The next time around, we will enjoy their jugalbandi...
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The missing link

Numerous ways and means have come up to value equities. There is the favourite price-earnings ratio that examines price in relation to earnings or the return ratios that deal with profitability of a business. Then there are parameters that seek to value assets-- replacement cost, book value and net asset value. Of course, not to forget the queen of them all-the discounted cash flows. But the market keeps throwing unique instances that challenge these meansinstances that cannot be explained by the existing tools. Thus begins a new learning. And the process of evolution continues in the stock market. Better than the rest About two years back, bank stocks typically quoted below their book values. Their business was cyclical, closely linked to the economic upturns and downturns and so on. Then came HDFC Bank and ushered in a new genre in banking. It quoted at a price-to-book value of 8x when the market leader State Bank of India was at or below its book value. And it has retained its premium rating to this day. Dr Reddy's Labs, an Indian pharmaceutical company, has always been quoting a notch ahead of its Indian peers. And in recent times, it has even inched close to the MNCs like Glaxo and Hoechst. Another stock that has defied valuation norms is Reliance Petroleum. Studies of DCF --theoretically the best method of equity valuation--put a fair value of about Rs45. But that didn't deter the stock from reaching up to Rs70 levels, quoting way beyond the other oil refining and marketing companies. Instances of "expensive valuations" are perhaps most common in the technology sector. At the peak in February 2000 (did I hear you sigh?) Wipro was quoting at a price-to-earnings of about 400x. Now after a year, all the techs have fallen by about 70-80% of their peak values but Wipro still trades at a premium to all the listed stocks. I am sure you can recall enough examples where stocks have consistently traded at or over and above their fair value. That makes one wonder: Why do some stocks trade at a premium? Is the market blind in love? History has it that though at times the market is in the grip of blind frenzy or hapless panic, it has got its sanity restored sooner or later. Over a longer timeframe the market corrects its excesses. Then, is there something wrong with DCF as a measure of value? Again the answer is a clear "No". DCF in all its simplicity and elegance says that the value of a business is the present value of its future cash flows. Thus, the stock price should ultimately converge to the DCF value. So what is the cause of this gap between market value and the DCF value? Michael J Maboussin, Professor at Columbia Business School, has attempted to explain this gap with the concept of "real options". Real options? What does a company comprise of? It has its current businesses and it has opportunities. Companies get cash flows from their current operations. In addition to that, they have several strategic options that they can explore in future. Here, sample these:
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Flexibility - A company can set up a new manufacturing facility or plan line extensions of a brand (expand). It can get rid of unproductive plants (contract). It can defer a project for a more suitable time. Or it can get out of a line of business (abandon).
Contingency - A company can undertake new R&D investments or try out an innovative advertising campaign. These projects might have zero NPV but they have a crucial bearing on the company's future projects.
Volatility - Some companies operate in extremely uncertain environment and can adopt several courses of actions with changing scenarios.
All these are opportunities that exist and are valuable. However, it is difficult and premature to attribute cash flows to them. This is because the time span and the plan of action are very uncertain. DCF can do a brilliant job in projection of cash flows from a company's existing businesses. But it is practically impossible to calculate cash flows that a company can get from these opportunities. Thus DCF does not "capture" the value in these opportunities. But the forward-looking market values these opportunities nonetheless This is because these opportunities are value generating for the company. This is the source of the gap that one sees between the market value and the DCF value. One can bridge this gap by extending the concepts of financial options to these real life opportunities. Hence these are called Real options. A financial option is a derivative instrument called "option" that offers you the right but not the obligation to buy a commodity (say a stock) at an agreed price on a particular date. Similarly, companies have the right but not the obligation of entering into some opportunity during a particular period at a particular cost. Real options can complement the DCF method of valuation. A company can thus be better valued as a combination of: discounted cash flows of its existing business plus a portfolio of real options. For the market sees more than meets the eye.
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Real options at work

(We take our discussion on real options further. Just in case you have missed out on our first episode on real options, we strongly recommend that you take a look at "Real Options: The missing link".)
Visualise this company called Great Soaps and Detergents Ltd (GSDL). It has many good brands of soaps and detergents-people across social segments use its products in the farthest nook and corner of the country. Imagine the distribution reach that it must have to cater to such a wide audience! To retain its control over its raw materials, it even has its own chemical facility where it produces linear alkyl benzene (LAB)-the primary raw materials for detergents. The excess of LAB it sells to other users. An integrated player indeed! Its current financials look like this:
Equity Reserves Net worth GFA GFA Depn NFA GFA CMP
100 1000 1100 700 700 200 500 700 500
Sales Net Profit Cash Profit -
Rs (crore) 5000 500 550 -
Hmm?a return on net worth (RoNW) of 45%--quite a profitable business. A net profit margin of 10% is indicative of a stable business. Let's assume that the company is expected to grow cash flows by 20% for the next five years and 10% after that for its entire life. Taking the cost of equity as 21%, the net present value of the company works out to be Rs4052 crore. But for some reason the market seems to like this company a little too much. It values the company at Rs5000 crore (its market cap is 500*100/10=Rs5000 crore)-that's a 23% premium!! Convention says that one must sell the stock. After all, a good company might not always make a good stock. But the market seems to think otherwise for the stock maintains its premium on a consistent basis. Surely, you must have come across stocks like this one. It is in situations such as this is that real options help explaining the difference between the "fair value" and the "market value". Above, in our discounted cash flow (DCF) calculation, we have valued the current business of GSDL, ie the cash flows emanating from selling soaps and detergents. But is that all there is to the company?
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There are very many opportunities that GSDL can explore at some point in time. And chances are that it will.
It has a brand so powerful that it can extend that to related areas like shampoos. With its wide reach of distribution network, it can get into retailing. These are options to increase the scope of operations. This is called scope up option.
If it feels there is a growing market for the products then it can use its cash flows to extend its operations in new markets. This increase in size of operations is called scale up option.
Now supposing there is another cost effective raw material, XX. Can GSDL's chemical facility alternate between LAB and XX depending on cost efficiencies? This option of shifting to an alternative is called switch up or switch down.
GSDL may feel that the benefits of having its own LAB is disproportionate to the capital that is employed. So it might decide to totally exit from this-reduction in scope of operations or a scope down option. The capital so freed can be utilized for the more profitable soaps and detergents business.
Not all products yield the most profitable growth for large companies like GSDL. Then it might decide to abandon the less profitable products and this scale down option (reducing the size of product portfolio) can be valuable.
The company has the right but not the obligation to exercise these opportunities. What we are not sure is when or how the company will utilize them. But this does not mean that the value of these options is zero. Since it is premature to attribute cash flows to these opportunities, our DCF analysis puts "zero" value to these opportunities. It is for this extra "potential" that the forward-looking market chooses to value the company at a premium. So what real options suggest is very simple. A company has current businesses and opportunities. Thus, Value of a company = DCF value of its current business + value of its portfolio of real options. Notice a crucial characteristic of real options? The best part about real options is that it brings in strategy into play and hence makes a more realistic valuation tool. But before we get carried away by "real options", a caveat is due? What is the probability that GSDL has the ability to exercise these options? Taking this question further, does any and every company in the soaps and detergent segment enjoy these options? There are some qualities that the concept of real options presupposes.
What good are the real options to the shareholders if the management is incapable of understanding and implementing them? GSDL should have a competent management. Real options best apply to market leaders -they have the financial power and management vision to explore new opportunities. Moreover, since it is already a leader it has a more compelling need to identify new avenues for growth.
And finally, real options are most valuable when the conditions are uncertain. For an option the downside is limited; so more volatility provides a greater scope for an upside with a limited downside-clearly more valuable.
In fact, real options work best when these three criteria are in place. And these are the very reasons why two companies operating in the same business might not have similar option values. Now comes the billion dollar question: How relevant are real options in the stock market? If you remember the discussion started with an attempt to explain the divergence between the stock market value and the fair value given by DCF. There is little doubt that the market values opportunities. After all, they can generate value for the company. Implicitly, while talking about stocks we do talk of "potential" for companies. Real options provide a theoretical framework to put a number for what we loosely term as "potential". We will let Maboussin explain the relevance of real options in the stock market. Is it valuing the unimaginable? Yes Is the unimaginable valuable? Yes
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As an investor, what are your?well?options? Depending on your risk profile (and hence return expectations), there are three options that you can take:
Ignore real options and value the company for its present business. Needless to say that this is the most conservative approach. You value the company for what it is. You will not be willing to pay a premium of what a company could become. Your risks are lower but you will miss the miss multi-baggers.
Get the real option free. This is an "in-between". And this requires smart stock picking. You need to find companies that are quoting at or near their fair value of their existing business but which have some potential asset that has yet to yield revenues.
Or you could take the most aggressive option-identifying and valuing real options. This means you will invest in the "expensive" stocks in the hope of what they could emerge to be in future. Here the risks are highest but chances are that you will stumble on multibaggers.
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Return on assets
Return on assets (RoA) is a lesser-known sibling of return on net worth (RoNW) and return on capital employed (RoCE). Rarely will you find it springing out of research reports, quite unlike the limelight friendly RoNW and RoCE. But do not underestimate RoA. It treads in where RoNW and RoCE falter and in its own niche it turns out to be much more powerful then either of them. Before we go any further, a formal introduction with RoA is due. Return on assets is defined as net profit divided by the total average assets. Look at the components of RoA and its concept will be clearer.
Introducing RoA?
Net profit is the net of all types of income and all types of expenses. Total average assets are what the company has had working for it during the course of its business. (Do you notice that total assets is also a reflection of the total capital that has been employed in the business?) It is more prudent to take an average of assets of two years since the balance sheet gives a snapshot of the financials as on a particular date. What we are interested in is getting to know of the assets that have been in use for the entire year.
RoA tells us how much return has the company ultimately earned on every Re1 of asset that it has. (After all, ability to generate cash flows is what defines an asset). That's RoA in a nutshell. Now the questions that present themselves are: What does it do? And what does it not do?
Family snap-shot
It's another of those tools that help us evaluate a business. At Sharekhan School, while valuing equities, we have discussed a few other such tools. There is RoNW that indicates what is the ultimate return that a business earns by utilising the shareholders' funds in the business. Then there is RoCE that keeps its focus on a company's operating excellence (or the lack of it).
Return on net worth = profit after tax / net worth Return on capital employed = net operating profit less adjusted taxes / total capital employed Return on assets = net profit / total average assets
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Between the two of them, they give a good perspective of the profitability and capital efficiency of most companies--whether it makes soaps or drugs or heavy equipment or oil or cement. A bank has money as its raw material and money as its finished goods. It accepts deposits from people like you and me, and pays us some interest. And then it uses these funds as leverage-meaning it loans out the funds at a higher interest. The difference between the interest that it pays to the depositors and the interest that it gets from its loansalso called 'spread'-is the money that the bank makes for itself. So unlike any other company a bank does not have clearly distinct operating and investing cash flows. To calculate operating profit, one needs to distinguish between the interest expense towards depositors and towards others. Similarly computing capital employed is also not so easy. Since deposits are used for commission, they are not strictly capital employed in banking activities unlike the shareholder's funds and other borrowings. Plus the provisions and other liabilities towards bad debts should be excluded from capital employed for a bank. Since operating profit-PBDITA-is difficult to isolate and capital employed in the business need to be computed differently, RoCE is not so useful while valuing banks.
But banking? What about banking?
What about RoNW?
A bank operates at high leverage. It's liabilities-its deposits--run into crores of rupees. They are far higher than the net worth of the bank. Its debt:net worth (D/NW) is in the region of 13-17 (incomparable to any other business). But mind you, there is nothing wrong with this per se-that's the way the business is. D/NW has little relevance in a bank. Sneak a glance at the table. Table: Interesting features that distinguish a bank
xx State Bank of India Bank of Baroda Corporation Bank HDFC Bank ICICI Bank
Debt/NW (x) 17.0 16.0 12.7 13.3 9.0
NW / TCE 4.6% 5.5% 6.8% 6.4% 9.5%
RoNW 18.2% 16.4% 21.9% 22.0% 14.4%
RoCE 20.9% 27.8% 38.0% 25.7% 15.9%
RoA 0.8% 0.9% 1.3% 1.5% 1.1%
** Note:- NW=Net worth; TCE=Total capital employed; RoNW=Return on net worth; RoCE=Return on capital employed; RoA=Return on assets
This also means that net worth is but a small portion of total capital (less than 10%) that has been employed in the bank. Taking only return on net worth (RoNW) as a measure of capital efficiency would not at all give a complete picture. What more, given the quantum of loan that the bank extends on its borrowed funds if loans go bad, then it can endanger its net worth. Thus due to the peculiar nature of a bank's operations and due to the way RoNW and RoCE are defined, these two measures are inadequate by themselves in revealing the operating capabilities of a bank.
It takes the net profit-that includes the impact of interest spread, the operating efficiency and the risk profile. And compares it against the total assets that the bank has given out as loans. What it shows is the profit that the bank has earned on its assets-which is essentially the capital that has been put at risk. The asset that the bank has is the loan portfolio-that is earning a commission by way of interest. Thus the profits made should be examined in relation to the total capital. Like RoCE and unlike RoNW, RoA concerns itself with total assets (which is nothing but equal to the total capital employed). Thus, RoA is a better proxy than RoCE. Secondly, since borrowing and lending is the basic business model of a bank, interest expense and interest are a part of its operations. It is difficult to distinguish between operating, investing and financing activities. Hence it makes sense to take the net profit instead of the operating profit. Like RoNW and unlike RoCE, RoA takes the net profit. Therefore, RoA steps in to fill a gap. And hence proves to be a more powerful and useful performance yardstick in evaluating a bank. Taking the principle to a generic level, RoA is useful in a business where most of the funds are deployed in assets that have been loaned out and are earning a commission.
That's where RoA enters and fills in the gap
What makes RoA a suitable tools for evaluating a bank?
Can you think of some other industries or companies where RoA finds utility?
Hmm?need to think, right? Now you know why RoA is not so widely used. The NBFCs that have banking like activities can obviously be judged using RoA. Or think of a leasing company where equipment are leased out. Or a company like Hitech Drilling that has two rigs, which are used by oil exploration companies like ONGC. Its gross fixed assets stand at Rs134 crore-these are old and hence highly depreciated taking the net fixed asset to Rs70 crore. The total asset is Rs132 crore. This reflects the business model of Hitech Drilling-the company's assets (the rigs) are hired out to the companies in return for a fee that is called as a rig rate. Should you want to measure the business prowess of Hitech Drilling, you need to check the return on assets. Summing it up, RoA is very useful in a niche-businesses where the entire asset earns a commission.
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You know the basics. Now you are eager to know how to make money. Learn the tricks of being a smart investor. Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 8: Portfolio Strategies Chapter 2: Understanding Chapter 3: Investment Markets Strategies Better Chapter 6: Trader's Handbook Chapter 7: Futures and Options Chapter 10: Psychology of Investing
Chapter 5
Everything about the groovy styles of investing in stocks... Article 1: Of value investing | Sep 6 2001 Value investing is like buying a TV during the festival season when every manufacturer is tryin... Article 2: Growth Investing | Sep 16 2000 'Growth Investing' School bets the farm on the Future... Article 3: Margin of Safety | Dec 13 2001 What does the value investor look for? Come, let us delve deeper into his mind. Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Investing Styles Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Of value investing
Should you buy Growth? Or should you buy Value? You should buy what makes you money said the wise guy. Growth vs. Value investing is one of those debates that have been around for ages now and you can be sure that in the year 2050 the inheritors of your portfolio will still be at it, hammer and tongs. Because, they are two diametrically opposite schools of thought on the way to make money in the stock market. But why re-invent the wheel? Let us first turn to the Gurus who wrote the book on what both these schools of investing stand for. For Value stocks we turn to Sir John Templeton: These are stocks selling at substantial discounts to our appraisal of their longer term, intrinsic value. Generally, we choose solid companies whose stock is trading at prices that are unduly low in relation to their value and potential. And for growth stocks here's the word from the doyen of growth investing, Mr. Thomas Rowe Price, a pioneer of this approach in the late 1930s: Growth stock investing focuses on well-managed companies whose earnings and dividends are expected to grow faster than both inflation and the overall economy. The real test for a growth company is its ability to sustain earnings momentum even during economic slowdowns. Such companies will provide long-term growth of capital, preserving the investor's purchasing power against erosion from rising prices, he predicted. Now that we have the words of the masters let's delve into the Value school today and next time we'll dig deeper into growth. Buying a Dollar for 50 cents Value investing is a very simple concept. As Warren Buffett, the legendary investor and disciple of Benjamin Graham put it, its all about "...buying a Dollar for 50 cents...". So if you find a cement company which is trading at Rs120 a share, (like say ACC is) and you believe that the intrinsic value of the company is actually Rs200 per share because that is what your analysis of its business, assets and prospects justify, then you would jump to buy it because it would clearly be a bargain buy. Value investing is a lot like buying an Arrow shirt at their Annual sale. Or Buying a TV during the festival season when every manufacturer is trying to woo you with a 'value for money' offer - 20 DVD's worth Rs9000 free with a 14' TV priced at Rs14,000. As you can see, in both instances there is an element of waiting for the best bargain and buying at that opportune time. Just like the shopper who scours the market for the best bargain before making his purchase, the Value Investor hunts for stocks that are ' trading at prices that are unduly low in relation to their value and potential.' Price Earnings ratios, Price /Book ratio, Enterprise Value/Replacement value, Dividend yield, Liquidation value. These are the metrics by which Value investors typically place great store. Low P/E & P/B ratios, a discount to replacement value, a high dividend value and a discount to liquidation value can get a value-oriented Investor highly excited. What does the value investor hope for? That sooner or later the asset will trade at a price more reflective of its Intrinsic value and then he, who bought it at a bargain will be sitting on neat little pile of money (profit). One of the most popular delusions about value investing is that it is all about liquidation value and does not look at an enterprise on a going basis. Some harsh critics would have us believe that Value investing is the equivalent of investing by looking in the rear view mirror. However, the words of the
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masters indicates otherwise. Let us go back to the words of Sir Templeton and focus on his choice of 2 phrases - '...longer term, intrinsic value...' and '...prices that are unduly low in relation to their value and potential...'. It should be quite obvious that 'Longer term Intrinsic value' is not and cannot be a function of the past. And mark the use of the word Potential in the second phrase - that again implies a peep into the future. Here's Ben Graham, the author of Security Analysis & Intelligent Investor, and the father of Value investing on the same subject. While it is true that it is the expected future earnings and not the past that determines value, it is also true that there tends to be a rough relationship or continuing connection between past earnings and future earnings. In the typical case, therefore, it is worthwhile for the analyst to pay a great deal of attention to the past earnings, as the beginning of his work, and to go on from those past earnings to such adjustments for the future as are indicated by his further study. What we are driving at is that 'Value' investing does not ignore the future. It merely attributes a lower probability of being able to successfully predict the future. The attributes of a Value Investor Value investing places a great premium on a virtue called Patience. If you are the kind of shopper who rushes into a shop to buy what you came for and rush promptly out, then value investing is not for you. On the other hand, if you are the type to walk into 10 shops, compare prices and work out the arithmetic of the special offers before making up your mind, then value investing might be just what the doctor orderd. The value investor does not mind waiting for a bargain to come along - the annual Arrow sale, the festival season... But that is not the only reason why Patience is a key virtue for a wannabe Value investor. It's one thing to possess the tools and the knowledge to figure out that something is trading below its intrinsic value. But you make money from an undervalued stock only when the price finds it correct levels. That happens when more people recognize the fact that the stock is undervalued. And that can be a long, long wait. The fact that value investing places a premium on patience in a round about way again reinforces our belief that Value investing is not a backward looking tool. Think about the cement company in question. As per your estimate its intrinsic value is Rs200 per share today. But remember, its not what it is worth today, but what it will be worth on the day that the market correctly prices it, that will determine the profits you make. What if a new revolutionary technology reduces the cost of building a cement plant by 20% due to a change in the manufacturing process? What if Dupont or BP develops a new plastic that does away with the need for cement next year? Then what? It would be only fair then to presume that in those circumstances ACC's intrinsic value would follow suit and head lower. The Intrinsic value as estimated today is based on our knowledge of the factors that impact the company and our ability to forecast them. The moral of story is that you can ignore the future only at your own peril. And a Value investor must recognize that. The great Value investors knew that. What the Value investors are looking for is Margin of safety. They are looking at buying a stock at as much of a discount to Intrinsic value as possible. This provides them with a margin of safety because the future is always difficult to predict! Growth investors on the other hand have their eyes firmly focused on the future. Next time we'll dig into their side of the story.
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Growth Investing
We've already got a grip on what Value Investing is all about. If you read our piece on Value, you'll remember that its mostly about patience. On the other hand, the Growth School bets the farm on the Future. Growth investing, as defined by Mr Thomas Rowe Price, a pioneer of this approach in the late 1930s, is: Growth stock investing focuses on well-managed companies whose earnings and dividends are expected to grow faster than both inflation and the overall economy. The real test for a growth company is its ability to sustain earnings momentum even during economic slowdowns. Such companies will provide long-term growth of capital, preserving the investor's purchasing power against erosion from rising prices. Ok, that's simple enough. This is of course the 'In' school for the past few years. Growth investing has been trouncing value-based investing for the past few years by a wide margin. While we have little data for the Indian market, there is a wealth of it on such issues about the US market. And if you look at the chart below it is amply clear that Growth has been the way to go for the past few years.
The basic assumption underlying growth stock investing is that these companies have above average rate of earnings growth and that over time their stock prices will reflect this growth. The difference between growth and value investing is best understood by the following question. Would you rather buy a great company at a good price or a good company at a great price? Growth investing places great store in buying great companies at a good price. Not necessarily at a great price.
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The metrics of growth investing are very different from that of value investing. They do not place great emphasis on tools such as P/E, P/B, dividend yield or Replacement value. Growth investors tend to look more at the future. So they are more concerned with prospective P/E's and PEG ratios. In other words they are more concerned with the company's P/E based on 2004 earnings than with 2000 earnings. Since they place great store by Intangibles such as brand value, technology edge et al, they typically disregard measures such as Replacement value and Book value. Measures such as Replacement value and Book value are based on accounting entries in the Balance sheet and do not therefore capture the intangible assets of the company. The intangibles could be the company's brands, its human capital or its IPRs. Also, since they are typically on the lookout for high growth businesses, they disregard dividend yields. Not without reason - fast growing companies justifiably prefer to reinvest their profits in their business rather than pay them out. Irrespective of whether you are growth or value investor, Management is always a key attribute in buying a stock. But with a growth company, where the job is not just to maintain consistent but higher than average growth rates, the nature of the challenge faced by management is of a higher order. Without any prejudice to the Value school, it is fair to presume that the premium placed on management quality by Growth investing is definitely in another league altogether. The same applies to interest rates as well. Typically Growth stocks are more sensitive to interest. This has more to do with the growth premium than with debt
levels.
Growth premium? Given their steady but above average growth rates, growth companies obviously get more attractive during the period when interest rates are low or are headed lower. However when interest rates head higher, then the value of the future cash flows gets impacted quite substantially and the appeal of growth companies does suffer as a consequence. Also, remember that Growth stocks get a lot of their value from future cash flows. Typically, the impact of future cash flows in a stock's current valuation is much higher than that for a value stock. But when interest rates rise, the value of those future cash flows drops very rapidly, hence making the stock more vulnerable to interest rates. The key issues that a growth company faces are 1. Can it sustain its rapid pace of growth? 2. Can growth be financed internally or does it require borrowing money? 3. Is the company growing faster than it its peer group? (This is particularly important because in a favourable business environment a lot of companies will record high growth rates. The key is to identify whether this growth is an industry wide phenomenon or whether the said company has a key advantage that is propelling it at a higher growth rate than the peer group. And whether that advantage is sustainable.) 4. Does the management have the ability to manage this growth? The question of how to value growth stocks is one that has no straightforward or simple answers. Unlike Value investing which is quite well defined and has easy to understand metrics, growth investing is more difficult to quantify. Discounted Cash Flow (DCF or NPV) is the only tool that an Investor trying to evaluate growth companies can turn to. The catch is that DCF involves several assumptions :
the rate at which cash flows will grow, the period of the explicit forecast (for which cash flows have been estimated), the interest rate to be used to discount the future cash flows (because money to be received tomorrow has a lower value today ) an estimate of terminal value (the value at which one expects the stock to trade at the end of the explicit forecast period).
The DCF model has its roots in what is called the Dividend Discount model. It owes its origin to John Burr Williams who introduced this model in his Theory of Investment value in 1938. In his words, "In short a stock is worth only what you can get out of it. Even so spoke the old farmer to his son: A cow for her milk A Hen for her eggs A stock, by heck For her dividends" This is obviously no easy task, because it involves complex calculations and many assumptions. But this remains the only way to value growth stock. It is because it involves so many assumptions about the future that growth investing stands apart from value investing. And because Growth investing is less about a rule-bound approach, it is quite easy to err. Growth stock investors would do well to remember this warning from Warren Buffett in his 1989 Chairman's
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speech "In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends. A high growth rate eventually forges its own anchor. Carl Sagan has entertainingly described this phenomenon, musing about the destiny of bacteria that reproduce by dividing into two every 15 minutes. Says Sagan: "That means four doublings an hour, and 96 doublings a day. Although a bacterium weighs only about a trillionth of a gram, its descendants, after a day of wild asexual abandon, will collectively weigh as much as a mountain...in two days, more than the sun - and before very long, everything in the universe will be made of bacteria." Not to worry, says Sagan. Some obstacle always impedes this kind of exponential growth. "The bugs run out of food, or they poison each other, or they are shy about reproducing in public." So which is the better way to make money? Growth or Value investing? As history shows there have been many investors from both schools who have met with great success. The key to their success has been their discipline and commitment to following what they understood best. Investors who play musical chairs between these 2 styles run a greater risk. The risk of following the wrong strategy at the wrong point!
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Margin of Safety
'What the Value investors are looking for is Margin of Safety. They are looking at buying a stock at as much of a discount to Intrinsic value as possible. This provides them with a Margin of Safety because the future is always difficult to predict!'
That is what we said in our piece on Value Investing. If you have not read it, we suggest that you may want to do so before reading this story.
It is clear enough from the above statement that when you buy something at a discount to its Intrinsic value then you enjoy a degree of safety in relation to that investment. The Value Investor aims to buy a genuine Rs500 note (not the fake variety) for Rs200. He is equally willing to buy it for Rs300 or Rs400. But as the price climbs and gets up to Rs499.99 he turns cautious. The reason for his behavior is quite simple. As the price climbs closer to Rs500 the Margin of Safety is eroded. But that should be obvious enough to all of you. As for the issue of calculation of Intrinsic value there are several methods that you could adopt - Liquidation value, Replacement value Book value or even Dividend Discount Model (Discounted cash flow). The choice of method depends on what you believe is most relevant to the stock you want to evaluate. But what of the intangibles? However as we move away from the mechanical and quantifiable to the metaphysical and the world of ideas, it is far more difficult to establish Intrinsic value. For a company like ACC we could choose very easily to go with Replacement value as the best estimate of Intrinsic value. That is not very difficult to calculate. But how do you estimate Intrinsic value of companies such as Infosys and HLL? Obviously the traditional Balance Sheet based measures do not help you arrive at a benchmark. These companies take their value from many an intangible asset, which makes the simple Replacement value or Book value based estimates meaningless. There is no option but to value them as a 'Going Concern' - based on their future profits (Earning streams). In other words you have to turn to models based on Discounted cash flow. But that is no easy task. Several imponderables underpin a forecast It involves projecting the company's profits for many years into the future. It requires making an assumption about that rate at which the company will grow. And underlying that single assumption are several assumptions about how the market for the company's products will evolve, whether their management will continue to be as focused as you currently believe them to be, how competitors will behave or respond, what regulators might or might not do in reshaping the competitive environment and technological obsolescence. In reality there are hundreds of imponderables underlying that one simple growth estimate. The Margin of Safety is meant protect you against those imponderables. But the Margin of Safety is also meant to protect you against one other error. In the words on Benjamin Graham:
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While it is true that it is the expected future earnings and not the past that determines value, it is also true that there tends to be a rough relationship or continuing connection between past earnings and future earnings. In the typical case, therefore, it is worthwhile for the analyst to pay a great deal of attention to the past earnings, as the beginning of his work, and to go on from those past earnings to such adjustments for the future as are indicated by his further study. You cannot properly buy an investment security on the basis of expected earnings, where these are very different from past earnings -- and where you are relying on new developments, as it were, to make the security sound, when it would not have been sound on the basis of the past. But you may say, conversely, that if you buy it on the basis of the past and the new developments turn out to be disappointing, you are running the risk of having made an unwise investment. We find from experience, though, that where the past Margin of Safety that you demand for your security is high enough, in practically every such case the future will measure one. This type of investment will not require any great gifts of prophesy, any great shrewdness with regard to anticipating the future.
In other words the basic Principle underlying the Margin of Safety is one of 'Continuity'. In the words of Graham:
It is also true that there tends to be a rough relationship or continuing connection between past earnings and future earnings.
We are not suggesting that you drive with your eyes fixed on the rear view mirror. What we are however saying is that what you see in your rear view mirror holds the key to what you will see (in front of you) through the front windshield of the car. Going rosy-eyed When you project the earnings that the company is likely to earn over the next 10 years in an attempt to arrive at an Intrinsic value, you would do well to remember that. Many an investment mistake can be attributed to projecting a rosy-eyed view of the future for a company whose past never justified such a forecast. But first a word of caution about looking at the past. The past is not just the year gone by. The past is a normalized and reasonably long period of time over which a trend can be discerned. Say 5 years. In other words look at what Tisco's profit growth over a 5-year period has been when estimating its future growth rather than just the last 2 quarters - in which its profits have grown by over 100%. Why Margin of Safety? There are 2 types of mistakes an Investor can make - buying a bad stock and buying a good stock at the wrong price. Nothing other than rigorous analysis and discipline can prevent the first mistake. But there is a method to prevent the second mistake. The Margin of Safety. According to Graham there are 2 methods of analysis and investing, which emphasize value. Margin of Safety
l protects you from

imponderables 'Continuity'
l is based on the principle of l prevents you from buying a

good stock at the wrong price
The first division represents buying into the market as a whole at low levels; and that, of course, is a copybook procedure. Everybody knows that is theoretically the right thing to do. It requires no explanation or defense; though there must be some catch to it, because so few people seem to do it continuously and successfully.
The second method emphasizes the concept of Margin of Safety and underpins Value Investing:
The thing that you would naturally be led into, if you are value-minded, would be the purchase of individual securities that are undervalued at all stages of the security market. That can be done successfully, and should be done -- with one proviso, which is that it is not wise to buy undervalued securities when the general market seems very high. Don't forget that if Mandel or some similar company sells at less than your idea of value, it sells so because it is not popular; and it is not going to get more popular during periods when the market as a whole is declining considerably. Its popularity tends to decrease along with the popularity of stocks generally.
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Next time you buy a stock, don't stop at asking yourself if you are buying a good stock. Also ask the question - Am I buying a good stock at the wrong price? If you enjoy a Margin of Safety on your purchase then it is likely that you are buying at the right price.
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You know the basics. Now you are eager to know how to make money. Learn the tricks of being a smart investor. Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 8: Portfolio Strategies Chapter 2: Understanding Chapter 3: Investment Markets Strategies Better Chapter 5: Investing Styles Chapter 7: Futures and Options Chapter 10: Psychology of Investing
Chapter 6
Chapter 6: Trader's Handbook
Ever wondered what it takes to be a good trader? Learn how to swing the odds in your favour... Article 1: Trading is war | Nov 11 2002 What does the Man from Mars have to do with a battlefield? Article 2: Entry or Exit: which is tougher? | Jul 23 2002 Tough questions that you have to answer everyday. Well, the answers are tougher. Article 3: The pain of taking profits | Aug 2 2002 You think taking profits is the most pleasurable trading activity? Think again. Article 4: Talking turkey | Sep 5 2002 If you think that turkeys are stupid birds, think again. For traders can be stupider. Article 5: The monster exposed | Nov 14 2002 We look at the dark side of trading in equities--Loss.
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Article 6: Taming the beast | Nov 5 2001 The market is unpredictable and the only, we repeat only, way to protect yourself against the m... Article 7: Traders swing both ways | Aug 13 2002 Call a trader a dirty opportunist and he will thank you for the compliment. Article 8: It's not about buying stocks | Aug 29 2002 We bring you a concept that will turn all that you know of trading on its head. Article 9: Why bother protecting profits? | Sep 2 2002 It is not everyday we ask such obvious and stupid questions. We must have something important t... Article 10: Thrill of the chase | Nov 19 2001 Nothing can beat the adrenalin rush of riding a profitable trade and getting off just before it... Article 11: Using the protective stop | Sep 5 2001 We take a real-life example to illustrate how protective stops can be actually used. Article 12: Are traders better lovers? | Sep 9 2002 What makes a trader tick? What gets him up at four in the morning? Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Trader's Handbook Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Trading is war
That is the most apt description of trading or speculation. Trading is about waging battles, more often over periods of minutes, hours and days than over weeks or months. When it comes to investing, there are not just Black and White but innumerable shades of Grey. In trading you are either a winner or a loser. Your gains are somebody else's losses and your losses are somebody else's gains. A trader believes in making absolute profits. What makes life difficult for a trader is that trading is unpredictable. And in an unpredictable world things will go wrong. The beauty is that what is wrong for you is not necessarily wrong for the other. It's like a half-filled mug of beer. To you it may seem the end of the world because it's halfempty. To somebody else, the glass is half-full and life is beautiful, thank you. When the Vajpayee government fell in April 1999 it seemed like the end of the world to many traders. The recent tech sell-off in our markets had a large number of traders diving for cover. To those who were long it must have seemed like the end of the world. Those who were short are still laughing all the way to the bank. The crux of the problem Remember Murphy's Law? 'If things can go wrong, they will.' Well, he must have been a trader. There's no way he could have come up with an insight of that nature if he was not. Governments may fall, Crises may occur, Scams may happen, The Dow Jones might crash, the Nasdaq might rally, or China may invade Taiwan. But as a trader you must realize that you will not be able to anticipate these events. Very often these will come as a surprise to you, even as somebody else out there will be gloating. Trading is a risky business because the focus is on the short term - hours and days. Hence, events that are but a blip on the scale of time can take on a larger than life dimension in the short term. It can be stressful Of course it is. Trading is a very glamorous profession, but it is accompanied by significant downsides. It is not an easy life. It can turn you into a night owl these days. It involves getting hooked on to CNBC or pulling up quotes at Yahoo all night. But it need not be that way. If you play the war by the
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rules, then you will be able to sleep peacefully at night. 'Peace comes not from the absence of conflict in life but from the ability to cope with it.' Nice but what's that got to do with trading? It can be related to almost anything in this less than perfect world. In the trading context, it reads thus - 'Success (in trading) comes not from the absence of uncertainty but from the ability to cope with it.' The important thing is to have a plan to combat the uncertainty. The key to coping: discipline To be a successful trader discipline is a must. It's the key ingredient that sets apart the winners from the losers. In fact, we would go to the extent of saying that trading is 99% discipline and only 1% about stocks and markets. The right view on the market does not help you make money. It is the ability to implement your view through a clear strategy that does. The IT refund approach How much money should you deploy in trading? Actually, this is a simple question to answer. The right amount of capital to invest in trading (particularly the leveraged type) is the amount of capital that you are willing to lose in entirety. Once you do this you will also ensure that you do not lose your sleep. Obviously the right amount of money differs from person to person, depending upon their net worth and their risk appetite. The right amount of money typically equals the amount of unexpected refund that you receive from the Income Tax department. Got it? You must be prepared to lose it. You don't need the Man from Mars The most common but misplaced objective that a trader can have is to hope to make money out of every trade he makes. We know of only one such person who has got every trade right and he is an alien, from Mars. So we are unable to translate the secret of his success for you. That's the truth. The objective when trading must very obviously be to make money out of it. Enough money to make it worthwhile. But that does not mean that you have to make money out of every trade. You only have to ensure that the sum total of all your profits is higher than that of your losses. If you get nine out of 10 trades wrong but lose only one buck on every wrong trade and make 10 bucks on every losing trade, the arithmetic is still positive. Set yourself a realistic goal. Not the one that sets you up for failure. Our thumb rule for money-making is as follows. We hope to make money 6070% of the times that we initiate a trade. And every time that we go right, we hope to make 2-3 times what we are willing to lose when we go wrong. Convert that into numbers. Let us say you make 10 trades every month. And you make 6% (on your capital) every time you go right, and that you lose 2.5% every time you go wrong. Overall, you would have made 28.5% on your capital. The beauty of the arithmetic is that even when your success ratio drops to 30% (for the month) you are still breaking even! Battle versus War? The Stop Loss is the Holy Grail of trading. It is the point at which you must cut your losses and retreat from the battle. In trading, as in war, you are better off extricating yourself alive from a losing battle rather than becoming a martyr. 'Live to fight another day,' is the motto of a successful trader. To go into battle without the Stop Loss is the equivalent of going into battle without a retreat plan. Sure you'll die a martyr and they'll build a memorial, but that is hardly the objective. You must be mentally prepared and must accept the fact that battles will be lost; what matters is that the war must be won. The Stop Loss is the point at which you must admit the failure of your strategy and retreat from the battle. It is nothing but the amount of capital that you are willing to lose on
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a trade. Sibling rivalry How do you fix a Stop Loss? You start with the win-fail ratio. To understand the concept of the win-fail ratio you must revert to your sibling days. Did you have a younger sibling who suddenly became mama's darling, displacing you? Now, you could pinch Junior once while mother wasn't looking, but by the third pinch Junior would wail and mother being all-knowing would respond to the crime with a tight slap. That's the win-fail ratio. 3:1. Now, if Junior were to wail loudly at the first pinch and you're going to get your just desserts for just one infraction, would you take the risk? No way. That's hardly an attractive risk-reward ratio. Are you prepared to lose one buck just to gain one? It's the same when you buy or sell a stock. You do not risk Rs100 if you hope to make only Rs50 from that trade. You should risk Rs100 only when you hope to make Rs300. Vice versa, you should be prepared to lose Rs100 if you hope to make Rs300. And if you do lose Rs100, then it's time to call it quits. Ever tried pinching Junior again - immediately after getting the sharp slap? We would not advise it. If you have reached this far then you know exactly how much of capital to deploy in trading. You have also understood sibling rivalry, battles et al and are no longer in pursuit of the Man from Mars. It's time to wrap it all up into what we call Sharekhan's Rules for trading. Prepare for battle You must have a plan of action before you reach the battlefield. You cannot decide on your strategy (on the fly) after you reach the battlefield. You must take stock (no pun intended) of what you are willing to lose before you trade. As obvious as this may seem, the same is difficult to do. The trading screen is evil personified. The flashes of red and blue, and the whispers and shouts, are nothing but the handiwork of the Devil. Do not allow the excitement of the moment overtake or change your plans. Don't take more pain than you planned for... The beauty of a plan lies in its implementation. Follow your strategy (as planned earlier) on the battlefield. If you lose the maximum that you were prepared to, then you must cut your losses and exit the battle. Not to do so would jeopardize your capital. It will ruin your sleep at night. As they say in Poker - 'To win, you need to be at the table.' You will not be able to keep your place at the table if you allow your capital to evaporate. Do not over trade Trading indiscriminately and in large quantities is a weakening process. You can fight a battle on one, two, or maybe, three or even four fronts, but beyond that you run the risk of spreading yourself too thin and letting the enemy get the better of you. Monitoring each trade puts pressure not just on your capital but also on your mind. Failure to recognize this can prove fatal. The mind can focus on only so many things at one point. Let your profits run, cut your losses early Let your profits run and cut your losses early. Put simply, go after the enemy who is already on the run, retreat from the battle when you are finding it difficult to hold your position. To do otherwise would be foolish. This is the rule that, in our experience, traders find most difficult to implement. The desire to parade our successes is so strong that it makes us close out the winning trade so that they may be celebrated. It also makes us leave our dirty little secrets in the cupboard. Instead announce your little mistakes (don't allow them to grow) to rest of the world and see how forgiving the world can be. Not to forget how well
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you will sleep at night. As for the winning trades, stay with them and allow your profits to soar. You must have started with a Stop Loss, keep hiking the same, as the trade turns profitable. How does this work? Let us say you bought a stock at Rs10, expecting it to go to Rs20. Being a sensible trader with a powerful recollection of your sibling days, you set your Stop Loss at Rs7. Let us assume that the stock goes to Rs15. You must now move your Stop Loss higher. After it has risen by Rs5 it hardly makes sense to leave your Stop Loss where it was and risk the possibility of losing Rs3. So you hike your Stop Loss to say Rs12. This way, even if the stock reverses its trend, you still get out with a small profit. Keep hiking your Stop Loss in the same direction as the price, and pretty soon the Stop Loss would work not as a 'Stop Loss' but as a 'Protect Minimum Profits'. Beautiful. What do you do when the stock gets to Rs20? Then you re-evaluate it as a new trade and apply the time tested sibling rule to set a new Stop Loss and a fresh target. If you think that Junior now realises that he should wail at one, then it might be time to get off the gravy train. Never treat this as an old trade or a free trade. There is no such thing as free trade. Focus on the price Focus on the price and cut out the noise. What's the noise? The noise is nothing but the fundamentals of the stock, which may be, and are, very often irrelevant when you are trading short-term movements. So don't pull out the balance sheet of the company when your trade starts to go horribly wrong. When you are trading, the price on the screen tells you everything you need to know. Also, don't look for news to convince you that what you are doing is right. If you wish to be a trader then you must buy on the rumour and sell on the news. The news tells you when it is time to get out; it's not to be treated as a reinforcement. If you have reached this far then you have been outfitted with the weaponry for battle. But the battle must be fought by you and you alone. Go forward.
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Entry or Exit: which is tougher?

We had asked this question last week. There are many variations to this question. A more obvious one is, which is more difficult, exiting at a profit or exiting at a loss? Another angle on this is, why is it more difficult to reenter a trade that has just been exited? There are so many questions to be answered. We had originally intended to just stick to the basics. But what we are delighted about is that you asked most of these questions. It is heartening that what started out as a simple query, was given multiple dimensions by fellow Sherus responding to our question. In that sense, you have defined the scope of this article. And we are thrilled to bits. We are going to be addressing each of these angles in a series of articles. Let's start with simple entry and exit. Let's assume that you are making a fresh trade. Let us assume for simplicity's sake, that the entry will be to buy and the exit, to sell. The theory however holds equally good for initiating a sell trade. We maintain it is harder to exit than to enter. In other words, it is tougher to sell than to buy. While entering a trade, you have the luxury of picking from a million options. You have the option of waiting and taking your time about it. You may have the money in the bank, but you have the choice of waiting till you are absolutely comfortable about buying. Enter at will There are a million reasons that you may have for making or not making a fresh trade. You can wait for the market to turn bullish. You can wait for the fundamentals of the company to become positive. You can wait for the right technical set up. You can wait for the institutions to step in and show you the way. Or wait for the market to come to the strongest support level. You can even wait for your gut to speak to you and tell you that this trade is the one to fund your daughter's education in the US. You essentially are in no compulsion to buy today. If you miss one opportunity, the next one presents itself almost immediately. Consult the stars You even have the choice of being frivolous. You don't need to buy today because you, being superstitious, are worried about that black cat that crossed your path this morning. Or maybe the reason you don't feel like initiating a trade is because you have a lunch date with your girlfriend and you don't want to be thinking about your position while whispering sweet nothings into her ear over soup. You can wait for the planets to align themselves to your satisfaction, so that your trade has the blessings of the Gods. You may even wait for the auspicious time of the day before you buy. Or you could decide to buy next week. Or next month. Or maybe never again! don't have to buy.
J Whatever the reason, you
Sticking your neck out But having exercised the choice and made a trade, you are committed to it. You no longer have the luxury of ignoring it or turning your back on it. You also no longer have the choice of not taking a decision on it. You have to decide when to exit. And this decision is always difficult because you are no longer playing by your rules. You are playing by the rules of the market. You now have to start praying that you have read the market right. And in doing so, you will be amazed at the number of doubts that creep into your mind. The trade that you waited patiently to make, confident that it's a sure shot, will suddenly acquire all kinds of ambiguities. Every bout of selling in the stock will make your palms sweat. Every adverse news report will give you palpitations.
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Transfixed You will notice that you can't take your eyes away from the last traded price for the stock. But you can't get yourself to stop. Your work suffers. Your concentration is shot to hell. You have lost your appetite. And the more money you can't afford to lose, the worse is your condition. You are close to becoming dysfunctional. You will be faced with all kinds of questions. Should I sell much below the profit target? Should I book the loss and get out? Should I wait for a bounceback to sell on the rally? What if the rally does not come? Should I wait till tomorrow? Should I carry forward the position to the next settlement? You call your broker. You ask your friends. You re-read the research reports, to see if there is something that you missed. Nothing helps. And then you come to Sharekhan looking for help and you end up reading this. Your confidence is shattered. You are reduced to praying. Enter very carefully Which is why, even though it seems like the easiest thing to do, you must put all your time and energy into making the entry decision. Buy into a company whose business you know. Buy it for reasons you understand and are comfortable with. Do not buy it just because somebody asks you to. Have a good idea of the potential profits you can make on the trade. Make sure the profits are large enough to compensate for the hazzles you will go to. Having done that, define the amount you are willing to lose on the trade. Buy a stock only if the risk-reward ratio makes sense. If it doesn't, wait till the price falls to a level you are comfortable with. Buy because a stock is going up, not because it is going cheap. Usually there are good reasons for it to be going 'cheap'. The better your buying decisions, the less trouble you will have in dealing with the ambiguities that come with the exit decision. May you find a 10 bagger every month!
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The pain of taking profits

Earlier we talked about how exiting a position is tougher than entering a position. We also concluded that it is important to bring to bear all one's skills and judgment into taking a position. You can follow this link to our earlier article if you want to read this in perspective. A quick recap Just in case you want to get on with it pronto, here's a...what else, quick recap. Basically, we said that before entering a trade, you must explore the choices, take your time. You must be sure to do it on your own terms. Make sure the trade has enough profit potential. Also, make sure the downside (as defined by the stop loss level) is a drain your wallet can weather easily. And returns are to be seen only in the context of the downside. You should not look at a trade unless you stand to make at least 2.5 times the amount you are willing to lose. If a trade does not fit these parameters, forget it. Look for the next one. There is a profitable trade born every second. The more careful you are about taking a position, the easier it will be for you to exit the trade. In the final analysis, a trade is exited only for two reasons. To take a profit or to stop a loss. Profits? Aaaarghh... Since we are all eternal optimists, let's share our insights into what should be the most pleasurable of all trading activities. Taking profits. But is it really pleasurable? Read on. The familiar adage is "Cut your losses, let your profits run". Sounds simple doesn't it. And totally logical too. But believe you me, this is probably the most difficult of all trading strategies to implement. How many times were you faced with a situation where the stock goes on to double from the point at which you sold it? What stopped you from riding the stock all the way? Why is it so difficult to sell at or close to the top? The most obvious reasons are fear and greed. Both these reasons work in combination, one moving in when the other fades out. This is how the fear-greed cycle works. Fear comes... After a trade is made, there is fear to begin with. Fear of losing the profits that the market has graciously allowed you make. Fear, emerging from the lack of total conviction in the trade. Fear, fed by conflicting market information, rumours and opinions. These fears push you toward booking profits early. You rationalize the whole thing by saying that cash in hand is worth twenty times the amount available in the market. "With the market being so fickle, better to get out while we are ahead. So let's book", you tell yourself. After all, as the saying goes, "No one made a loss by booking profits". ..to be replaced by confidence... Let us assume you were able to overcome these fears and hang on to a position. As you watch profits grow, so does your confidence in the trade. The very influences that gave you cause for worry earlier seem to matter even less. Confidence soon gives way to over-confidence. You start to strut. You start to brag. Totally understandable, since you can't ever do that when you make losses. Unless you are lying. Which is also totally understandable. After all who wants to admit to losses. We do, for one but that is a totally different issue. ...which also is short lived Getting back to your trade, you find that the price is starting to top out. It struggles to hold on to its highs. Everyday it slips a little. You are watching, but aren't overly concerned. You are still sitting on a good profit, right ? So what if it is unrealized. You just have to sell, and all that money is yours!
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You think this is just a correction and the stock will begin to rally soon. Then suddenly there is a big sell-off and the stock is at the lower circuit (aka limit down). You are shaken. You decide enough is enough, and at that point mentally resolve to sell on the next bounce. But the price continues to slip lower. (In this context a rapid sell off is better in making you react than a gentle gradual drop in prices. This kind of price action lulls you into believing nothing serious is afoot.) Fear, our old friend, comes back for a visit As prices continue to fall and your unrealized profits continue to shrink, the fear comes back again. The much-anticipated bounce back just doesn't come. But you are still waiting for it. A new fear sets in. Fear that the market will reverse all the profits and leave you holding a loss-making position sets in. If you are disciplined enough, you sell and get out of the trade. But for most people the fact that they missed the opportunity of taking much larger profits gnaws at the insides. They continue to hold. They are almost frozen into inactivity by this fear. They wring their hands in dismay and lose sleep over their position but they find that they just can't get out there and sell. They find themselves incapable of reacting to the erosion of their dreams. If you are lucky you will grit your teeth and sell at a small loss. ...and stays You could have booked your profits at any point. But would you have been totally happy? Either you would wish you had made a little more as the price continued to rise after you sold. Or you would wish that you not missed the sitting duck opportunity to make a little more by selling earlier. Either way it is your emotions that make profit-taking a less than perfect joy. Next time, we will look at how to purge these emotions from the profit booking process. We'll discuss some techniques that will allow you to make the most of a profitable trade without letting your emotions get in the way. May the Gods of the market bless you with profitable trades!
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Talking turkey
We are willing to bet that you have not forgotten the story of the hare and the tortoise even though you heard it when you were still a toddler sitting on your mother's knee. And we are sure you remember its moral too: slow and steady wins the race. That is the power of using stories to convey a message. We are going to use the same technique to tell you some truths about the market. In effect, we will be trying to recap what we have learnt so far, so that every time you are faced with a tricky situation while trading, you can draw inspiration from this tale. Story time, folks! This is a story that will illustrate the concepts of profit-taking much better than all the features we can write on it. A story that was told to us when we were babes in the market and stayed in our memory indelibly. There was this hunter who used to make a slow but steady income hunting wild turkeys. He used go down to the nearby forest, string out this net from the lower branches of trees and sprinkle some birdseed under it. More often than not, a turkey used to come for the birdseed and then graduate to becoming someone's dinner. He had a steady (and ready) market in the form of the local bird-man. And a relationship that was strictly of the cash-and-carry kind. A steady return. Although the income couldn't support a golf-every-evening-and-drinks-followed-by-dinner-and-cigars kind of lifestyle, he was quite comfortable, if a bit lazy. But who doesn't have an eye for the big league? One day, while our hero was waiting with his net spread out, not one but three turkeys walked in. And just as our hunter was having visions of an unexpected (but very welcome) two-day holiday, three more walked in. And what do you know, before our man of the moment could say Rio de Janeiro, three more walked under the net while two stepped out. Enter Greed. The hunter, already seeing visions of an extended 10-day holiday on the beach, decided that he would drop the net as soon as the two that had walked out came back in. Meanwhile, one more stepped out. He decided to wait for that one to come back too. Turkeys, after all, are stupid birds. Enter Indecision. While he was waiting, the three explorers returned but five others ambled out. His vision of the beach started clouding. He decided that when three of the five came back in, he would drop the net and go home with 7 birds and a week off. To cut a long story short, he kept waiting as the birds trotted in and out, until there was only one bird under his net. With his visions of the beach and bevies of Hawaiian beauties shattered, he finally decided to quit while he was ahead. He dropped the net on that one bird. And went home, the same as every day, as if the windfall that could have been his never happened. Back to steady returns. Tut, tut. Now who would you say was the turkey? Think about it. What could be a trade to bring in windfalls is often botched up simply because you are unable to decide when to take profits. Exiting a position is tougher than entering one In the first and second parts of this series, we argued that exiting a position is more difficult than
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taking one. The basis for this was that, till such time that you haven't entered a position, you could play by your own rules. But once you are in a trade, you are at the mercy of the market and have to play it by the market's rules. You are forced to take a decision on that position. We then went on to say that it is because you are forced to take that decision that you find yourself under pressure from a series of conflicting emotions - ranging from fear to greed to over-confidence to doubt and fear again. And so, more often than not, you end up taking a sub-optimal decision. Employ strategy, not emotions to guide selling decisions What we have tried to introduce here is the element of strategy. If Saddam Hussein, the Iraqi dictator, were a stock trader, he would call a lack of strategy the mother of all reasons people lose money in the markets. In the next feature in the 'How to make money and have fun doing it" series, we introduce the most important element of trading strategy. Stop losses. And in the course of doing so, we will be delving deep into various techniques of obliterating these emotions from the trading process later.
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The monster exposed

There are essentially three outcomes to exiting a trade. One, exiting at a profit. Two, exiting at a loss. The shades of grey lie in the third scenario where we consider exiting at a predefined profit, letting our profits run with a trailing stop loss and exiting at the stop loss level. And it is in these areas that traders have the most problems. Let's deal first with that nasty thingy called 'loss'. Let us try and understand the nature of this monster. Even God can't help you here! Wouldn't it be great if you did not have to ever take losses on your trades? Well there is one person we know who never had to take a loss on the market at all. God. Unfortunately, we don't know how he does it. And we never will. Oh yes! We did ask him, when we took a few phone calls from panicky traders a couple of weeks ago. Desperate souls with quavering voices and sweaty palms holding huge loss-making positions and not knowing what to do with them now. (Have you ever heard a trader with a profit speak shakily?) At that point, we picked up the hotline to heaven and dialled the magic number. And the answer we got was always the same. It's too late. God didn't tell us his fail-proof strategy. What he did instead was to give us lesser mortals a computer and the option of cutting our losses. So here we are, taking the circuitous route of covering the whys, whats and hows of `stop losses' in detail. Some ugly truths about the stock market Having decided to make a living trading equities, it would do us good to step back a little and look at the kind of animal we are dealing with: the stock market. There is no way of predicting what the market will or will not react to - or how it will react: From genuine earnings surprises to rumours of income tax raids on the big brokers, from the Nasdaq to the Prime Minister's knee problem, from FII buying to the overthrowing of the Fiji government, there is nothing that the market doesn't take a view on. One of Murphy's laws is, "If anything can go wrong, it will". This is one of the inescapable realities of life and markets. What's more, the market has the annoying habit of reacting to just about anything, anyway. More often than not, the market will react to events that have very little significance in the long run. But such events, which would be the tiniest blips in the scale of time, would have moved the markets sufficiently to wipe you out of home and hearth. A trade made based on the strongest tip or the best research is just as likely to go wrong (or right) as the one picked by an anteater poring over the stock pages: When the market dropped a stomach-churning 1010 points in eight days in mid-July 2000, Finance Minister Yashwant Sinha was quizzed on whether he had any theories on the situation. "Nothing to get worried about. The market has its own logic," was his considered reply. Easy for him to say -- not his money. (Or he was happy to be short.) But he was right. The market does have its own logic. A logic that is a messy amalgam of the opinions of trillions of people. You could try fundamentals, technicals, technofundamentals, financial astrology, tealeaf reading and tarot cards, but the market will do what it will. You would be a genius to be reading it right more often than not.
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Losses are as integral a part of trading in equities as profits: Since markets are so unpredictable, you have to live with the truth that, just as sure as sunrise, there will be trades on which you will take losses. Like we said earlier, only God doesn't lose money on his trades. (Incidentally, we are of the firm belief that the good Lord is the greatest Punter of them all. He created the world, put man and woman in it, and then went short on mankind. He is yet to cover his position. And, looking at the mess we are in, it is unlikely that he will for a long time.) Why a stop loss strategy at all? What comes through from all this is just one thing: markets are unpredictable. And the only, repeat only, way to protect yourself against the market's unpredictability is to use "stop losses'. Most importantly, if you wish to make a living out of trading on the stock markets, you cannot afford to lose large portions of money on every trade and still hope to stay in business for the long haul. The market has effortlessly emptied the deepest pockets, simply because there was no strategy to protect capital. Look at it this way. Putting in a stop loss is not a sign of lack of conviction in your trade. It is a sign of lack of conviction in the mood of the market. Trading is war Try thinking of trading in equities as going to war and of every trade as an attack. It's okay to lose an occasional skirmish, but the objective is to win the battle. And that would be possible only if you, having aborted your attack, are able to come back again the next day and launch the next one. You have to stay in the game. You have to be alive to be able to come back and fight another day. And the only way you can be alive the next day and not be a faceless statistic in the annals of history, is if you have a stop loss protecting your capital from major erosion. Lose the battle but win the war The stop loss is the point at which you decide that a particular attack has failed. The point at which you retreat from the battlefield with your capital intact, nurse your wounds, recuperate and watch the market for the next opportunity. Without a strategy for cutting losses, you run the risk of losing so much on every trade that you are a financial and emotional disaster before the first week is over. You, in effect, martyr yourself trying to win the war of stock trading without arming yourself with a survival kit. They may declare a national holiday in your honour, but that is not going to do your bank balance any good. ZZZZZZ... OK. We have now come to a point when we realise that if we go any further we run the risk of you falling asleep at your terminals. We have taken a peek at the dark side of the market and understood why we need a stop loss to protect ourselves from the market's mood swings. In the next article we will actually go into the mechanics of setting a stop loss. So watch this space.
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Taming the beast

Hope you managed to live through our previous article on stop losses and liked the experience. That way you will be in context and we will be on the same wavelength. Hopefully.
Okay, we doubt if we have said anything so far, that most traders don't already know. Everyone knows about the unpredictability of the markets. Everyone knows that using stop losses is an effective method of dealing with the uncertainty. But despite this, we also seriously doubt if most traders use stop losses. Why? Its not because they don't realise the perils of trading without one. It is not because they find the arithmetic of setting a stop loss so difficult that they can't figure it out. It is just that they can't get themselves to do it. 'Stop loss' is not a four letter word We remember this time when we advocated the use of stop losses to a stock market veteran. He was quite upset that we were talking about losses even before putting the trade on. "Shubh shubh bolo", he admonished us. Most traders relate to stop losses as being something negative and pessimistic. Frankly, we don't see why. We don't know of anyone who burnt his or her tongue screaming "Fire". But we do know plenty who are thankful for their foresight in buying a fire extinguisher. Like we said earlier, using a stop loss is not a sign of your lack of conviction in the trade. It is a sign of lack of conviction in the mood of the market. A 'mental' stop loss is no stop loss The one thing you must know for certain before you put out a trade is what your cut loss level is going to be. And you must put this figure in at the time of entering the trade. You must actually key in the trigger and stop loss levels. A "mental stop loss" rarely works. The value of this method is easy to see. First, you clearly define at the outset the loss you are willing to take on that trade. Second, you set the process of defining risk in motion while you are feeling calm and unthreatened by the market. This way, you have the advantage of a logical and rational mind-set when you define your stop loss beforehand. But once the trade has been initiated, this mind-set is very very difficult to achieve. Once you have a position in the market, you no longer control the fate of your trade. The market does. And when you are sitting in front of the trading terminal, you are reacting (and not acting) on the spur of the moment to the market's every move. That is no frame of mind to take rational decisions from. Hope, fear, anger, joy, disappointment, greed - a variety of such emotions - stand in the way of your efficiently executing a stop loss and getting out of the trade before getting burnt. So how is a stop loss set? The simplest way of setting a stop loss is by deciding how much, in absolute terms, you are willing to lose before the trade is put on. And squaring off the trade when you have lost that amount. Though it may sound simple, traders find it the most difficult to implement. How does one decide how much one is willing to lose? The risk-reward ratio The most efficient way of setting your stop loss is by setting it in relation to how much is sought to be made on the trade. You will agree that a trade that offers a gain of 10% with a risk of losing 10% is not worth looking at. Why? Because, to start with, every trade already has a 50:50 chance of going right or wrong. The risk-reward equation of 10% either way does not improve these odds substantially. But if the same trade offered a gain of 10% with the risk of losing 2.5%, then the trade
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would make sense to you. Because this way the odds are stacked in your favour. The probability of making 4 times the amount lost is built into this equation. So then, the most efficient way of setting the stop loss level is to estimate the amount of profit potential in the trade and then divide the figure by four. This, when subtracted from the initiation price in the case of a long trade, will give you the level below which the trade must be exited. Illustrating the risk-reward ratio Assume that stock X is trading at Rs200 and you have reason to believe it will move up to Rs300. The way to trade this call would be to put a stop loss at Rs160. How? The minimum profit expected equals Rs100 (Rs300 less Rs200 equals Rs100). This divided by 2.5 gives Rs40. This when subtracted from the current market price of Rs200 will give the stop loss level of Rs160. That is, 200-((300200)/2.5). If, on the other hand, you expected the price of stock X to halve, then you would go about shorting it with a stop loss at 240. Again 200+((200-100)/2.5). Remember that what is important is only the relationship between the risk and reward. The absolute numbers do not matter. So if there is a trade that you think can earn you 40%, by all means work with a stop loss level of 8-10% below the current price. Three weeks in a trader's life Let's take some examples. Suppose you make 10 calls a week. How much money do you lose if you used the 1:2.5 risk-reward ratio?
. No of trades that made money % gain on winning trades % loss on bad trades Net gain/loss
AverageWeek 6 out of 10 6 * 2.5% 4 * 1.0%

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Bad Week 4 out of 10 4 * 2.5% 6 * 1.0 %

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Horrible Week Only 3 out of 10 3 * 2.5% 7 * 1.0%

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15% 4% +11%
10% 6% 4%
7.5% 7.0% 0.5%
Look at the performance in the horrible week. A net gain of 0.50%. Certainly nothing to write home about. But the point to be noted here is that by using a stop loss you have managed to protect your capital and keep it intact! The brilliance of this strategy is not only the risk-reward ratio, but also the leeway it provides you to control losses. You are guaranteed to make losses on some of your trades. And you don't need a second opinion on that. The objective in stock trading is not to make money on every trade (again one has to look to the skies for a method of doing that), but to make money consistently. I've lost more times than I've won. I am good! There have been many successful traders who claimed that the number of bad trades actually outnumbered the ones that made money for them. But, net-net, they still made money because they had no large losses and a few big profit trades. We always thought these claims were a bit exaggerated. Till we worked out the arithmetic ourselves and realised that it need not be so. If a successful trader claims his losses actually outnumber his gains, but that he makes money overall, we have no good reason of accusing him of exaggeration. But we still believe a good trader should make at least as many gaining calls as losing calls. Let's recap

You need to always work with a stop loss, no matter what your trading timeframe is. Traders always need to put in their stop losses at the time of initiating the trade. A mental stop loss is no stop loss. The best way to put your stop loss is to give yourself the advantage of a 1:2.5 risk-reward ratio at the very least. Your objective should be to make money consistently and not necessarily on every trade.
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Traders swing both ways

If there is one brahmastra in the trader's arsenal, it is his ability to go short. Taking that analogy further, a stance to only go long and not short would be like going to war leaving half your weapons home. Certainly not something that is advisable, unless of course you are looking to be a martyr. You must agree with the adage that the trend is your friend. If you suffer from an allergy to going short, then you must be specialist at wringing your hands in dismay. What else can you do when the market swings downwards, as it so often does? What is Short Selling? "Buy low, sell high" is the goal of both short selling and long buying in shares. A short sale reverses the order of a typical stock purchase: the stock is sold first and bought later. Just as a buyer buys in anticipation of prices going up so he may sell at a profit, a short seller sells in anticipation of prices going down so he may buy the shares back at a lower price. The difference is his profit. If you look closely, in both the cases the shares have been bought low and sold high. The only difference being that in short selling, you reverse the order of the transactions. Why Sell Short? The two primary reasons for selling short are opportunism and portfolio protection. Occasionally we see a stock that we believe has gone up too high too fast. Or we may see a stock struggling to get past a strong resistance. Taking a short position is the only way we can profit from both these situations. Short sales are also used to protect a portfolio against a market downturn. Short sellers rake in the moolah when stock prices fall. So when we think prices are going to fall, we diversify a predominantly long portfolio by adding some short positions. This way the portfolio will have positions that make money both when prices rise and when they fall. We then use the profits from the short sales to help offset losses in the long positions. This reduces the volatility in the portfolio's returns and helps protect the value of the portfolio when prices are falling. In defence of the short Oh! We can almost hear long-termers like our comrades managing the Hammock and Hot Chocolate model portfolios hiss and boo at the suggestion that short-selling is a nifty portfolio management tool. Don't listen to them. In the long term we are all dead, remember. They'll tell you that there is no need to short. They'll tell you not to worry about short-term fluctuations in the market. But the point is that most bear markets start with a tiny innocuous intraday blip that grows and balloons. And before you know it the bears are on the rampage, tearing your portfolio to shreds. (Now, we are not predicting a great bear market or a major crash, so calm down!) Why sit through a correction where your portfolio has the potential of losing, say, 10% of its value when you could possibly generate a positive return during the same period? Then, when the market turns up, you can get back to the long side and participate in the next leg of the bull market. Sounds like a smart thing to do, doesn't it? Acting and reacting But does that mean we react to every intra-day blip that pushes down prices. God! No. That's is a sure-fire, time-tested, quality-checked, guaranteed method of committing financial hara-kiri. As is the case with every trade, even a short call is put out only if the risk to reward makes sense.
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Which brings us to the other thing that the folks at the Hammock and Hot chocolate would make noises of disapproval over. The risk in a short trade. A short could turn into a long sad story Short-selling stock is an extremely high-risk transaction. The potential gains are limited while the potential losses are unlimited. That's right. Losses tend to infinity! How? The potential gains are limited to the size of the short sale. The lowest a stock can fall to is Rs0.50 (normally even the rottenest of shares manage to find a stray quote at Rs0.50). So it costs next to nothing to buy back the shares and close out the short sale. In this case, the profits almost equal the outlay on the original short sale, excluding transaction costs. The potential losses however are unlimited because a stock can keep going up in price indefinitely. Imagine if you had gone short on 100 shares of Infosys at Rs310 a couple of years back. (Price adjusted). Now that you have imagined what that would feel like, it's best you put it out of your memory. That is the kind of stuff nightmares and horror films are made of. Down on an up The other risk with taking short positions is that stock prices tend to rise over time. Betting whether a stock's price will go up or down is not like flipping a coin. (Thank God! Or we would be out of a job!
J) The odds are not even. Over the long term, stock prices on average do tend to trend up.
Also, the reason most people buy shares of a company is because they expect the company to make profitable investments that will make the value of their stock go up. (We do know of a few who buy stocks so that they can use the loss as a tax hedge. Guess there is no better place for that kind of service than the stock market! ) Betting that a stock will fall in price is betting against the trend. It does happen but the odds are against it. So, to keep a long story short, short selling can be a very profitable strategy to play the downside, it comes with so much risk that the losses could wipe you out of home and hearth if not handled with discipline and the right kind of tools. Like stop losses. But that is a story that has already been told over and over again.
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It's not about buying stocks

Likely. Maybe. Probably. Market analysis is filled with such words. What do these mean? We will answer that with another question. Suppose you buy a stock which has just cleared its previous peak and is showing no signs of slowing down. What are you really buying? Or, as is germane to traders like us, suppose you buy a stock that has been repeatedly finding support at its 20 daily moving average (DMA) at 1% above its 20DMA. What is it that you have really bought? If the answer to the last two questions is "I've bought the stock, stupid!" then you may be right but you are missing the point. What you have actually done is bought a probability. A probability that the price of your stock will move up. And the basis for the assumption is that market has since time immemorial tended to eventually move stock prices towards their fair value. And so long as there is demand for the stock to support this hypothesis, there is no reason for the market to act differently just to spite you. Not so 50:50 So the name of the game, friends and neighbors, is to get the probabilities right. It now all boils down to spotting the right probability on the right stock, and the rest can be as easy as hitting a wall at three paces. As speculators, almost 90% of our success depend on getting the odds right. Trading only when the odds favour the trade is the single most important difference between a speculator and a gambler. We predominantly use technical analysis (TA) to find the right odds for a tradeable move. We use TA to identify tradeable trends but what we are buying is only a probability. (And you thought all along that we bought stocks! ) Which is why it is so important to define the upside and acceptable downside. This we do by setting profit targets and stop loss levels. Given that a tick (which is the movement in a stock price from a single trade) is positive, the probability of the next tick also being positive is 50:50. But the trades we recommend do not work tick by tick. These instead take a view on what the trend is likely to be several days later. Obviously, the odds change as time goes by and a trend sets in. And once a trend is in place, the odds of the trend continuing are much larger than the odds of it reversing. Equally obvious is the fact that a 50:50 probability that applied from tick to tick is no longer valid. Bring out the crystal ball You will agree that dreams of a farmhouse in the hills with a temperature-controlled swimming pool are realised by trading BIG moves. Unfortunately, you have no way of predicting the odds of these big moves. To quote the Worden brothers, one of the more successful traders of our time, "In the business of stock trading, prediction has to be used pretty sparingly -mainly because the future is so stubborn about revealing itself. Prediction is a trader's euphemism for wishful thinking, if not delusions of grandeur."
Sweet dreams are made of these Small moves however are much easier to predict. Because in predicting a small move you are essentially playing a probability rather than a price forecast. And every trade starts off as an attempt to get a foothold into the stock which has a reasonable probability of trending in the short term. Having done this, you watch the changing odds very closely to see if you have to change your mind.
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The point at which the odds start to look shaky is where one would set a stop loss. The stop loss now works as the level at which the immediate probability of the price moving to your favour reverses. This also explains why stocks sometimes manage to move in the direction of your original call after stopping you out in the first move. Because, while the immediate probabilities are against you, the stock some times builds a larger longer-term probability of a trend in the direction of your original call. But again, there is no certainty that this may happen always. Foot in the mouth? Having got your foot into the trade, you wait till the position starts to draw out profits. And as the stock continues to trend strongly, by moving stronger probabilities in its favour, you stay on the trade for the big moves. This is the way all big moves are traded. Once the stock starts behaving the way you want it to, you keep tinkering with your profit targets and stop loss levels to protect most of the profits. This way you will be able to get the most of what the market wants to give you. The Worden Brothers liken the initiation of every trade to taking a little trip in the right direction. They go on to say, "If you can be right about the trip (the trade) and the stock is still strong, you may decide to stay for the journey. It is like taking a car trip. You feel your way. You handle the curves on the road as you come to them." But there is no way of predicting the long road you will be travelling before you start the journey. Such large moves come very rarely. And you never know them in advance. Most trades fizzle out early. This is where the rationale of using stop losses can be most appreciated. If you manage to break even or take small profits or losses on most of the trades, and use the same techniques to ride the big ones, then these big trades will make up for all the small losses and 'maybe', it is 'likely' that 'probably' there might be enough gravy leftover for you to keep those dreams of a farm house alive. May the road rise to meet your step!
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Why bother protecting profits?

How is anyone supposed to answer the question "why bother protecting profits?" The answers are so obvious. And "elementary," as Holmes would say. Still you would be amazed how often traders allow their profit making positions to turn cancerous.
Au contraire
The market abounds with seemingly contrary adages. Someone exhorts you to "cut your losses and let your profits run" while someone else warns you to "never let a profit turn into a loss." Someone else wisely advises, "Nobody lost money booking profits." Leaves a trader quite puzzled about what to do.
It's simple, really. The one way to reconcile these sound but contradictory homilies is through the use of a protective stop loss. How is a stop loss different from a protective stop loss? While a stop loss is used to control your absolute losses in the context of the reward that is expected from the trade, a protective stop loss is used to ensure that the rewards that accrue from a trade are protected. There are two ways of taking a profit. One is to set a pre-defined profit taking target and exit the position at that level. The biggest drawback of this strategy is that if the trade has more profits to offer than what you have taken with a pre-defined profit target, you would not be in a position to capitalise on it. The only way to make the most of what the market has to offer, the only way to "... let your profits run..." is by using a protective stop loss.
Taken for a ride!
The other drawback of using a pre-defined profit target is that the stock may never make it as far as the profit target at all, despite making lower profits! Most of us lose money on our trades not because we don't see profits, but because we don't know how to protect our winnings. Our favourite analogy to describe the situation is that we get on to the notorious Mumbai local at Vashi with a ticket for Chatrapati Shivaji Terminus (VT to those who don't believe in being politically correct). But unfortunately, the train reverses at Wadala and by the time we get off, the train is at Panvel! Often trades that start making money will fall short of the reward expectations. If we used only an original un-updated stop loss to protect us, it is very likely that not only will our profits erode but the stock will also move down to change a profit making trade into a loss making one, as we watch helplessly. While the original stop loss is good enough to make sure we don't lose more money than we intend to, the protective stop loss (which is essentially the original stop loss updated to protect some portion of profits) will make sure we take home at least some of the profits that we have fought so hard to make. The protective stop is also the answer to the trader's quintessential dilemma of when to book profits. Get out too early and you may miss the bulk of the move. Don't get out early enough and you may end up giving a large portion of your profits back to the market. (And you thought taking profits would be a relatively painless process!
Profits can be so elusive
J)
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So which is the best time to exit a profit making trade? When you have made enough money? (Can someone please explain this elusive concept of "enough money"? ) Or is it when your friend who gave you the tip, sells his position? (We would treat that friend like a prince, because that's what he is. Most tip-giving friends usually don't bother to tell you when to sell. Unless it is a week after they have sold, when the stock is trading 20% below its current peak! A protective stop loss puts the decision right into the hands of the ultimate arbiter, the market itself. It allows us to let the market decide when we have to exit a profitable position. If the market, in all its benevolence, feels like we deserve more profits than what we wanted in the first place, the protective stop loss makes sure we are there to receive the largesse. If the market, in all its spitefulness, decides we don't deserve the ambitious profit targets we have set for ourselves, the protective stop loss will allow us to get out with most of the gains we have made. At the very least, it ensures that we don't incur losses that erode our precious trading capital. Trade well!!
J)
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Thrill of the chase

Don't we often feel that the market has victimised us? Well, the truth is that this feeling is only a reflection of the misplaced and unwarranted sense of our own importance in the larger scale of things. The truth is the market does not even know we exist. If at all we are victims, we are only victims of our own defective trading strategy. The inability to read the market right is not as big a mistake as not having the right defensive mechanisms in place to deal with the possibility that our reading of the market could be in error. A stop loss is one such mechanism that protects trading capital in the event of the reading of the trade going wrong from the very beginning. A protective stop loss is a mechanism to maximise the returns on a trade that has gone right. A protective stop loss is used to guard against the contingency that while we might have got the direction of the trade right, we may still be wrong about the trade's profit potential. Now let us try and act out the protective stop loss. Two conflicting forces need to be reconciled while using a protective stop loss. Set the stop too tight and the stock might take it out in a volatile swing and resume the original trend without you. Set it too loose and you might defeat its purpose entirely. So where and how does one put in a protective stop loss? There are no black and white answers to this question. As with the answer to everything else, the answer to this question too revels in shades of blue!
The push and pull of a protective stop loss
Where you will set your protective stop loss will be a function of four factors. 1. How trendy the market is. If the market is in a long trending mode (which our market has not seen for a very long time), then you can set the stops a little loose. If the market is choppy, then it makes sense to keep tighter stops. 2. How trendy the stock is. The trend in the stock and the market trend may not necessarily be in sync. The stock may be under or over performing the market. The protective stop loss then needs to be set after considering both the market trend and the stock specific trend. Since most stocks cannot move against the market for long, it is advisable to keep the stops tighter if your trade is running contrary to market direction. 3. What your risk appetite is. The Braveheart has a much higher risk profile than the Punter. To a day trader, the Punter's risk-reward profile would be ridiculous. If you are the kind of trader whose hands start itching to close out his position when the stock shows the first 5% in profits, then you would be happier with tighter stops.
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4. Where the supports and resistances of the stock are. Assume we are long on Reliance Industries at Rs340 levels and are currently earning 7% on it at Rs364. If the stock has huge supports at Rs350 levels, it makes little sense to put your stop at Rs355 because the stock might slide below Rs355. And in the process it might get you out of the trade (courtesy your tight stop loss at Rs355) and then resume its move upwards.
Introducing the correct thought process

Okay. Having said all this, let us Whoever said trading is easy? introduce you to a broader line of thought. An example of how a protective stop loss may be set. a. Use you original stop loss to get out of the trade. Get into the trade in the first place only if you can see the stock returning at least three times what you will lose with the stop b. Move the stop to protect capital once the trade starts to return between 3% and 5% in profits c. Move the stop to protect 66% of the gains if the gains are between 5% and 10% d. Move the stop to protect 50% of gains once total gains are within 10% and 15% e. Move the stop to protect 80% of gains once the trade starts to return over 15% Let us reiterate that these rules are only indicative of a thought process and need to be suitably altered to adjust for the factors mentioned earlier. Let us take a real life example. Assume we buy HFCL at Rs1,332 (the closing price as on November 23, 2000), as the stock moves above the previous two days' prices and starts another uptrend. With a stop loss at Rs1,259, we are willing to risk 5.5% on the trade. We are looking at 23% return; over four times the risk at a price target of Rs1,633, which is also a significant historical peak made in late August. Ambitious, aren't we?
Anatomy of a trade
Let us see how we go about maintaining the trade at every point using the rules to control the inherent risk and protect profits. At Rs1,390, we don't move our stop loss level even though we have 4% profits on the trade and our risk is still at 5.5%. It is important to give the stock space to breathe initially and allow the trade to weather the volatility that precedes the advent of a trend. Profit protection strategies on the HFCL Trade
-HFCL Stop loss November 23 November 29 December 1 December 6 December 13 December 15 December 22
1,259 1,332 1,390 1,453 1,500 1,572 1,317 1,107
Gains % gains 73 58 121 168 240 -15 -225 5.5% 4% 9% 13% 18% -1% -17%
% profit Move to Protect stop protect to (Rs) 66% 80 1,412 50% 84 1,416 80% 192 1,524 -
But once the trade starts returning between 5% and 10%, it makes sense to move our original stop to Rs1,412 from Rs1,259 and protect 66% of the gains made so far. Again when the trade returns between 10% and 15%, we should look to protect 50% of profits. The percentage to protect in the 10-15% slab is lower because stocks generally tend to go into consolidation in this range. With a confirmed trend backing the trade, it makes little sense to tighten your stops too much and get left out of further upside. If you don't like this, you are free to protect, say 70%, of profits. Whatever works best for you!
Getting out while ahead
Once the trade starts to return more than 15%, it makes sense to tighten the stops, if only to avoid losing too much money. With a protective stop at Rs1,524, we would get away with 14% profits when the stock falls short of our target and sells off quite violently from a peak of Rs1,584. Check the chart out. We have all the important levels marked out. Nothing like seeing the price movement on a chart to appreciate how a protective stop has saved our trade from turning into a titanic disaster.
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HFCL at Rs1,584?.sigh! Trade well!!!
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Using the protective stop

The earlier two articles on protective stops defined the usefulness of a protective stop and then detailed the thought process behind setting such a stop. In this write-up, we take a real life example to illustrate how the returns from a trade can be enhanced by scientifically using the protective stop. "Let's talk about a popular misconception about mistakes. In trading, the bottom line is God, right? When seen that way, most of us believe that if a trade makes you money, then it is a good trade. If it doesn't, then it is a bad trade. It's a mistake, right? We can see you nodding in agreement. Let us then ask you what happens to a trade that makes money, but a lot less than what you started off intending to make? Is it a good trade or a bad one? (We always have trouble with shades of gray, don't we?
J) "
This introspection was triggered by a comment (reproduced below) made on the site for our article detailing the nature of protective stops. Benam speak Mr Benam, a diligent follower of the Braveheart, our model trading portfolio, and fair critic had this to say:
Point taken that one should have trailing stop loss level to maximise profits but how to calculate that? In Braveheart we bought MTNL the other day with a profit target of Rs198 and stop loss at Rs173.2. We went as far as Rs193 but did not do anything to save our profit and were stopped at Rs173.2. To have that balance Rs5 per share we were forced to sacrifice Rs20 per share. Question is how to arrive at that level? We can't have you online and also in this market it is not practical to rush to you. Give us a method to calculate it. We decided to examine the trade in question to see if we had observed the guidelines we recommended for setting protective stops. In case you are new to the concept of protective stops, we recommend you read up the earlier two articles and put yourself in the loop. The following discussion will make sense only then. The bone of contention To start with, let us state for the record that we made money on that trade in MTNL. But was it a good trade? No. It could have been better. The MTNL trade involved accumulating 123 shares in two tranches at an average cost of Rs163 per share. (There is Table 1 below that gives nice blow-by-blow account of the trade, which you might ) The stop loss for the stock was initially set at Rs142 and was updated to Rs154 by like to see. the time the purchases were completed. The profit target was at Rs198. That worked out to a 5% risk for a 21% return. The table below lists the open profits on the trade for every day on which it was alive. It also shows how the stops were revised and to what extent they initially protected capital and profits later.
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If the bottom line is your God and you think a good call is one that makes money, then our call on MTNL was a good one. By the time it had returned 8%, the trade was completely shorn of risk. And by the time it returned 11% we had moved our stop to protect 56% of our gains. We closed the trade when it took our stop loss, leaving us with 6% profits.
Table 1: A blow-by-blow of Braveheart?s MTNL trade Profit / Loss Date 29-Nov 30-Nov Avg. Rate 08-Dec 12-Dec 13-Dec 14-Dec 15-Dec 18-Dec 19-Dec 20-Dec Qty 64 59 123 Rate 158 168 163 Close 161 165 165 176 181 189 186 186 178 177 173 In Rs 2 13 18 26 23 23 15 14 10 In % 1% 8% 11% 16% 14% 14% 9% 9% 6% Stop Loss Level 142 142 154 163 173 173 173 173 173 173 173 Risk % -10% -15% -5% 0% -
Estimating risk on an ongoing trade One of Mr Benam's contentions is that when we advocate a risk-reward ratio of 1:3, how did it make sense to risk Rs20 (the stop was at Rs173) for an upside of Rs5, when the stock was trading at a high of Rs193 on December 14? Fair enough. Point taken. At Rs193, the risk to Rs173 and reward to Rs198 were skewed. But there are other considerations that are as important as the correct estimation of risk and reward. While it is good trading technique to use a 1:3 risk-reward ratio while initiating a call, to use the same ratio at every point as the trade progresses would be to ignore other equally powerful trading tools like supports, resistances, historical turning points, indicators of momentum and trend. Attempting to maintain a 1:3 risk-reward equation through the life of the call will be counterproductive also because we would never reach our profit objectives as the heightened volatility that comes with a trending stock will invariably stop us out. While initiating a trade we always try and find the best fit of risk-reward and other indicators. To maintain a trade we shift our focus from protecting capital initially to subsequently protecting profits by using trailing stops. The prime considerations in setting these stops are other indicators of trend and momentum rather than pure estimation of risk and reward. Doctor! heal thyself! Mr Benam's question however got us thinking whether we could have handled the trade better. So we decided to see what would have happened if we had applied the guidelines on setting protective stops to the MTNL trade. We were amazed at the results. Check Table 2. Just to refresh your memory the guidelines involved: (1) moving the protective stop to protect capital when the trade is returning less than 5%; (2) moving it to protect 66% of profits when the trade returns between 5% and 10%; (3) moving it to protect 50% of profits if the trade returns between 10% and 15%; and (4) moving it to protect 80% of profits once the trade starts to return more than 15%.
Table 2: MTNL Trade - What was and what could have been Profit / Loss Stop Loss Actual Level 1% 8% 11% 16% 14% 14% 9% 9% 6% 142 142 154 163 173 173 173 173 173 173 173 Risk % -10% -15% -5% 0% 10 10 10 10 10 10 10 Profits Protected Actual in Rs -15% None 0% 10 10 10 10 10 10 10 As a % of open profit -15% -5% 0% 56% 39% 44% 44% 67% 72% 100% As per plan (Rs) -15% -5% 9 9 21 As a % of open profit -15% -5% 66% 50% 80% -
Date 29-Nov 30-Nov 30-Nov 08-Dec 12-Dec 13-Dec 14-Dec 15-Dec 18-Dec 19-Dec 20-Dec
Close 161 165 165 176 181 189 186 186 178 177 173
In Rs 2 13 18 26 23 23 15 14 10
In %
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We live and learn Check Table 2 again. The last two columns detail the trade in terms of what was actually done and what would have been the hypothetical results if we had used the guidelines. We had moved the stop to Rs163 to completely protect capital when the stock was returning 8% on December 8. So we immediately moved our stop loss to Rs173 and safeguarded 66% of the Rs13 that the trade had returned (163+{13*0.66}). The trade returned Rs18 or11% and we still retained the stop at Rs173, since it more than protected 50% of the profits (163+18*0.500=172). So far so good. But when the trade returned Rs23 or 16% in profits, we should have moved the stop to Rs184 (163 +{26*0.80}) but we didn't. As a result we made Rs10 (6%) on the trade when we could have more than doubled our profits at Rs21 or 13%. Check the graph to appreciate a graphical distinction between what was and what could have been.
Nothing could bring out the power of using scientifically set protective stops better than this real life example. And as for us, of what use is an experience if you don't gain something from it? We are nothing if we do not live and learn. Good traders never graduate from school! Trade well!
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Are traders better lovers?

"?I don't care too much for money, money can't buy me love?" -Beatles. At the end of the day, we are known and remembered by the relationships we build. Money can buy you love but that is much like a rally that is unable to sustain its highs. To be able to hold on to the love you receive, you need to follow that up by building relationships. Which is why we should be using every excuse to express our love to our near and dear ones. But what kinds of relationships stand the test of time? What is it that you would look for in the person you want to spend the rest of your life with? Most people would look for honesty, dependability and integrity. People also look for qualities such as a sense of humour and a certain level of sensitivity to make the hours together more pleasurable. "I love your eyes, nose, fingers, lips, etc, especially the etc" ---Anonymous Very often we are fortunate to find someone who fits the bill almost perfectly and the relationship that we build with that special someone tinges life a romantic shade of pink. Just as every garden needs careful tending for it to grow and bloom, we choose every opportunity to make the relationship work. But as time goes on we start to focus more on the object of our desire rather than on the reasons for its desirability. That is the distinction we would like to make here. The distinction between the object of desire and Traders are accused of being too mercenary with the desire itself. Desire for desire's sake? their affections and incapable of anything as lofty as loyalty to a trade. Unlike investors who know every nuance of the company they buy and hold on for years (and write love songs to their favourite CEOs and wax eloquently on their favourite companies at their AGMs accused of being incapable of building lasting relationships with their trades. Is there anybody going to listen to my story, All about the girl who came to stay? She's the kind of girl you want so much it makes you sorry, Still you don't regret a single day. Ah girl, girl. The popular mindset is to look disdainfully at anything short-term in nature and to treat long-term relationships as the only virtuous relationships. Traders are blamed for being unromantically opportunistic in using (abusing?) a trading opportunity and then moving on once they have got what they want. (Come to think of it, don't you think the Valentine day is a product of a deviously capitalistic mind? branded!)
J), traders are
J After all, it isn't as if we didn't express our love before February 14 became J
In effect, traders are accused of not being good lovers of stocks. And you know what! We couldn't agree with you more . Traders are lousy when it comes to falling passionately in love with a stock. But that is because traders rarely get time off from wooing the market to seriously pursue individual stocks!
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"She's the kind of girl who puts you down, When friends are there, you feel a fool, When you say she's looking good, She acts as if it's understood, She's cool - oh. Ah girl, girl."
Before you accuse him of being flirtatious, freewheeling and disloyal, understand that every trader worth his salt feels a deep sense of loyalty to his guiding principles--principles of protection of capital and profit. And before you label him philanderer, understand that he has actually been killing himself trying to make the best of this tumultuous and often destructive relationship he has with this tough lady called the market. Take a real life relationship. Assume you are in love with this girl, totally taken in with her nature and her sense of values. So totally in love are you that you think life without her is not worth living. Now also suppose that this girl of your dreams is so unforgiving that the slightest lapse on your part, the most innocent transgression, the smallest of infidelities, and she would dump you like a hot brick and be gone. (There are those who would question how any transgression can be "innocent" or any infidelity, "small", but we will let that go for now. ) Now wouldn't you strain every nerve and sinew to make sure you don't slip up? Wouldn't you always find ways to work this relationship? Wouldn't you be careful? "When I think of all the times I tried so hard to leave her, She will turn to me and start to cry, And she promises the earth to me and I believe her, After all this time, I don't know why. Ah girl, girl"??. The market is much like this girl of your dreams. A darling so long as you stay devoted to your principles. A ruthless demon when you slip up. To deal with this nature of the market, the trader has to be capable of immense loyalty. But the focus of his loyalty is not on the object of his desire as much as it is on whether the object of his desire still remains desirable for the original reasons. In dealing with the market, the focus of every trading relationship is on loyalty to the first principle. The core of every trader's existence is the protection of capital and the pursuit of profits. A trader by nature shows utmost loyalty to a trade as long as the basis for making that trade is still valid. The moment he finds that the basis no longer holds, his loyalty to his ultimate pursuit forces him to dump the stock. And the very same loyalty makes him look for the next trade.
"Was she told when she was young the pain would lead to pleasure? Did she understand it when they said? That a man must break his back to earn his day of leisure, Will she still believe it when he's dead? Ah girl, girl"???Beatles
A good trader does not get into any trade with the intention of having a short-term affair. After getting into the trade he places the onus of earning his long-term loyalty upon the stock. So long as the stock lives up to his expectations, he is comfortable and even happy being loyal to it (it is cheaper too, considering there is less brokerage forked out on a buy-and-hold ). But his loyalty to the first principle of protecting capital and profits overrules his loyalty to the trade when the stock starts to fail his expectations. Traders can have long affairs with specific stocks too. But they are very demanding in their relationship. It's only some stocks that pass the test of such a relationship most of the time. Most stocks live up to their expectations only some of the time. If traders are lousy lovers of stocks, it's because stocks rarely continue to live up to their expectations for long. So if you say that a trader "cannot live happily ever after with a stock", you are probably right. But can you fault the trader for it? "?if you can't be with the one you love, love the one you're with, love the one you're with?.."---CSNY
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You know the basics. Now you are eager to know how to make money. Learn the tricks of being a smart investor. Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 8: Portfolio Strategies Chapter 2: Understanding Chapter 3: Investment Markets Strategies Better Chapter 5: Investing Styles Chapter 6: Trader's Handbook Chapter 10: Psychology of Investing
Chapter 7
What are futures and options? What purpose do these serve? Find out more... Article 1: Enter the Futures Exchange | Oct 4 2002 Forward contracts are best known for their risk eliminating properties But these are also fraug... Article 2: Forwards- the prelude to Futures | Mar 3 2000 A forward contract allows you to fix your future. Can't beleive it? Read on... Article 3: Countering Counterparty risk | Dec 4 2000 Of margins and how they handle counter party risk Article 4: Introducing index futures | Dec 12 2000 What are index futures and how does one trade in them? Article 5: Pricing of index futures | Dec 15 2000 How are index futures priced and do they always trade at their fair value? Article 6: ignore | Nov 2 2000 There is no guarantee how long a bear market will last...but you need to...and there is only on...
Chapter 7: Futures and Options
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Futures and Options Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Enter the Futures Exchange

Hello, folks! Been watching this page vigilantly, eh? Still trying to figure out how Sohan and Mohan would have signed a futures contract if they had inhabited two different corners of the country? Well, we are back. Back with the solution and more. So, without much ado, let us turn the clock forward and leap into the world of forward contracts et al, and of Mohan and Sohan. For those who missed the bus last time... Mohan, the farmer and Sohan, the rice miller, had signed an agreement in the month of February one particular year to sell and buy, respectively, rice at a predetermined price of Rs12.50 per kg two months hence. Such an agreement is termed as Forward Contract. Now why did they decide to carry out the transaction at a predetermined price? Well, Mohan feared the rice prices to fall to Rs10 per kg by April that year while Sohan expected the price of rice to rise to Rs15 per kg during the same period. So, in order to avoid the price risk, they decided to settle for a middle course. Forward contracts are fraught with risks Now let us assume that Sohan was bang on target about expecting higher prices that April. For the country was faced with rice scarcity that year and the price of the crop soared to Rs15 per kg. Sohan was happy that despite rice prices rising to Rs15 per kg, thanks to the forward contract he had signed with Mohan, he would be able to procure rice at Rs12.50 per kg. However, as it happened on the day the transaction was to be carried out, Mohan defaulted on the contract, i.e. he refused to sell rice to Sohan at the predetermined price of Rs12.50 per kg. As a result, Sohan was forced to buy rice at the spot price of Rs15 per kg from the market. Well, Sohan was easily duped, as the contract that he had signed with Mohan did not involve any guarantee. And it is not Sohan alone, anybody who signs a forward contract runs the risk of the other party defaulting on it. And this risk is known as the counter-party risk. Almost all forward contracts are fraught with counter-party risk. That is one major drawback associated with forward contracts. Unfortunately, there are some more. Let us assume that Sohan is very well informed and has access to all information available on the rice crop, including its price the world over. Mohan, on the other hand, stays in a very small village with not much knowledge of the outside world. As an informed party in a forward contract, Sohan is in a better position to predict the price of rice and dictate the contract price in his favour. Hence, due to lack of equal distribution of information, one party in a forward contract is always at a disadvantage. Now imagine that in the neigbouring village, Ram is a farmer while Shyam, a rice mill owner. In that fateful February when Mohan and Sohan signed a forward deal at Rs12.5, Ram and Shyam decided to transact the two-month forward at Rs14.0 per kg. While Ram expected the price to rule at Rs13 per kg, Shyam expected it to be at Rs15 per kg. They struck their forward contract at Rs14 per kg. Two different expectations of the future price of rice. Which one does one choose? Of course, in our example, the price of rice in the month of April stood at Rs15, indicating that the contract between Ram and Shyam was closer to the price than the one between Mohan and Sohan. However, from both the forward contracts one had no way of knowing the price of rice two months in advance, as each contract had different price expectations for the same thing. Clearly, a forward contract does not help us to fix the price of an asset in advance. Hence, economists would state that
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a forward contract does not aid price discovery. Have we got you worried talking about the drawbacks of a forward contract? Worrying about the risks involved? Well, worry not! The Americans had thought of this way back in 1848. Which is why they established the Chicago Board of Trade (CBOT). The main objective of the world's first future exchange was to bring farmers and merchants together. The forwards traded on this exchange were standardised in terms of quality and quantity of goods, as also the place of delivery. These standardised forward contracts were popularly termed as future contracts. These future contracts were traded on future exchanges. A futures exchange provides a trade guarantee in case of all future contracts traded on it and therefore acts as a counter party for the contracts. In case of a default, it has to pay to the other party involved in the contract. Hence, the futures exchange eliminates the risk of default. The exchange also takes care of other problems associated with future contracts, like unequal distribution of information and, hence, no fair price, or price discovery. How? In a future exchange, there are many players who are well informed and can arrive at a fair price for future contracts. What is a fair price? Read about this in our next article. Meanwhile, if the traded price is different from the fair price, arbitragers step in and bring the traded price back to the fair price.
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Forwards- the prelude to Futures

Meet Mohan. He is a farmer by profession. He grows rice in a small village in Haryana. He sows seeds in the month of February and harvests his crop in April every year. Whenever there is scarcity of rice in the state, he sells his stuff at a high price. But when the market is glutted with rice, he takes a hit and has to dispose of his crop at a throwaway price. Risky business that, eh? Sohan runs a rice mill in a neighbouring village. He purchases the rice crop from farmers like Mohan, removes the husk from the crop and sells the rice in the market. There are years, when due to an oversupply situation he is able to procure rice at a favourable price. On the other hand, in times of scarcity, he has to purchase rice at an exorbitant price. So, his business is equally fraught with risk. One February few years back, Mohan expected the price of rice to drop to Rs10 per kilo by April that year due to oversupply in the market. However, Sohan expected rice prices to rise to Rs15. Mohan made up his mind to sell his crop at any price higher than Rs10. On the other hand, Sohan was prepared to purchase rice at any price below Rs15. They bump into each other at a cattle fare in Mohan's village. Soon they get talking and exchange views on their respective businesses. They learn about each other's view on the rice price too. To escape the risk associated with the price of rice, they enter into a deal as per which Mohan agrees to sell rice to Sohan at a pre-determined price of Rs12.50 per kilo. In other words, they entered into a forward contract. Though they sign the deal in February, the actual transaction is carried out in the month of April only. But what is forward contract? Well, it is an agreement to buy and sell an asset at a certain time in the future at a predetermined price. Now, consider this. If the price of rice had remained below Rs12.50 per kilo that April, Mohan would have made a profit and Sohan, a loss. But if the rice price had crossed Rs12.50, Sohan would have made a neat profit and Mohan would have taken a hit. But thanks to the future contract, nobody would have suffered a loss even if the price had gone against their expectations. It's a win-win situation for both How? After entering into the forward contract, Mohan could budget his general spending on the basis of the money that he would receive by selling rice to Sohan in April. At the same time, Sohan, knowing his raw material (rice) cost in advance, could also work out the selling price of the clean rice. Hence, forward contract helped both the participants do away with all risks associated with the price of rice. A forward contract not only helps one reduce the price risk associated with commodities but also eliminates the interest rate risk and foreign exchange risk. Assume that your company is planning to expand its operations. It expects to do so in the next two months and will need about Rs200cr to do so. However, the finance manager of your company is not sure as to what the interest rate will be like in the next two months. It may go up, in which case his company will have to borrow at a rate higher than the existing rate. It may even drop; in which case his company will benefit for it will be able to borrow at a lower cost. So, what does the finance manager do? Smart that he is, he approaches his company's bank and enters into a two-month forward contract for Rs200cr at a certain fixed rate. This forward contract is called Forward Rate Agreement (FRA). So, how does the finance manager benefit? Knowing in advance the interest rate at which his company will borrow, helps him work out the finance cost of the expansion project. And hence, the viability of
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the project. And how does a Forward Contract help eliminate forex risk? As you all know rupee depreciation hits importers while appreciation of the rupee affects exporters. However, at a given point of time exporters and importers can remove this uncertainty regarding the rupee's movement by signing forward contracts. How? Let us understand this better with an example. A textile manufacturer wants to import some textile equipment from the US. It will cost him a total of $1000, which he will have to shell out after two months. The current Rupee-Dollar exchange rate is Rs40 per dollar. But after two months, when the textile manufacturer will be required to make the payment, the Rupee-Dollar exchange rate is likely to be Rs45 per dollar! As is evident, the textile manufacturer's import cost will rise after two months in keeping with the depreciation in the rupee's value. So, how does he avoid this extra cost? He approaches his bank and enters into a forward contract to buy $1000 after two months at a predefined price that is little higher than the existing rate. This helps him know in advance his finance cost and hence eliminates the foreign exchange risk. But there is one problem regarding a forward contract. Assume that Mohan and Sohan live in two different corners of the country - Mohan in some village in Rajasthan and Sohan, in Tamil Nadu! How would the two meet and transact in such a case? How do they enter into a forward contract? But don't worry. Ever this problem can be solved. How? Wait and watch this place for the solution.
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Countering Counterparty risk

Some time back, we learnt that the futures are traded on a futures exchange, which works as a guarantor to all trades in futures and therefore take care of all counter party risk. But isn't it a big risk for exchanges? How does the exchange take care of this counter party risk? Default risk can crash the entire system Futures normally have a maturity period varying from one month to one year. If the futures exchanges settle these trades on the last day of maturity, then again the default risk becomes high. And suppose Mr XYZ has 40 futures contracts long and there are 40 investors with short positions in one contract each. Then if Mr XYZ defaults, 40 contracts will default and this may crash the systems completely. Let's answer this question: which is more risky, a full payment of Rs90,000 after 90 days and or a payment of Rs1,000 every day for next 90 days? Of course, the full payment after 90 days. The futures exchanges understand this and therefore instead of a settlement on the final day of maturity, they have opted for daily settlement of all the open positions in the futures. Smart fellows! But if even in this arrangement of daily settlement, Mr XYZ does not pay his one day loss, what happens to the other investors? How does the futures exchange take care of this one day default risk? An initial margin takes care of compulsive defaulters Future exchanges circumvent the really persistent defaulters using some very prudent measures, thus neutralising counter party risk. They require that both the parties involved in the future transaction pay an initial margin to the exchange. The margin is fixed based on the maximum historical price movement on the underlined asset. The BSE has set an initial margin of 10% on Sensex futures, while the NSE requires a 7% initial margin on Nifty futures. This initial margin is expected to cover at least one day's price movement in the Sensex or Nifty. (We will learn about the Sensex and Nifty futures in the following series). Futures are settled on a daily basis, depending on the market value of the future's closing price. But how does the daily settlement take place? Is it a very cumbersome process? In a word, no. Futures are cash settled The most beautiful thing about futures is that they are cash settled. There is no delivery of asset required of a party who shorts the future and vice versa. So if your position in a future makes a profit, then you receive cash. The daily settlement also takes place through cash. So if you are holding a long position in future and today it ended above yesterday's level, then you receive the difference between yesterday's price and today's closing price. This transfer of funds is also known as daily margin, which is based on mark-to-market basis. So does one have to take care of daily cash transactions? Margin account makes it easy In reality, when you enter into a futures contract, you deposit a certain amount in your margin account with your broker. Normally, this opening balance is above the requisite initial margin set by the exchanges. This extra amount is to take care of losses on your position in futures, if any. But what happens if the amount in the margin account becomes zero?
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The margin account can never reach zero level because your broker will not allow you to carry the position in the futures if the account balance falls below 10%. If your position in the futures keeps making losses and the account balance falls to 10%, then your broker will ask you to refill the margin account to 15% of the current exposure in the futures. So the losses in the futures have to be paid as soon your account falls by 5%. But what about the profit on your position in the futures? Are they being paid to you according to your margin account balance? Yes, the profit on the futures positions are also settled based on the balance in the margin account. So if your margin account balance goes above 15% of the current exposure, then you can withdraw this extra money from your margin account. But in practice, this is done once a week on a weekend. If your margin account balance is in excess of 15% of the current exposure on futures on Friday, then you can withdraw that amount on that day. Let's take a simple example of a future contract, which you bought at Rs1,000 on 3rd January 2000. The future behaved in the following manner for the next 10 days.
Date
Futures level 1000 980 970 960 950 930 945 960 995 1005 1080 1200 1185
Loss/ gain -20 -10 -10 -10 -20 15 15 35 10 75 120 -15
Margin a/c 150.0 130.0 120.0 110.0 100.0 80.0 154.5 169.5 204.5 214.5 289.5 282.0 267.0
% Of exposure 13.30% 12.40% 11.50% 10.50% 8.60% 16.30% 17.70% 20.60% 21.30% 26.80% 23.50% 22.50%
Margin Closing Margin %0f Call a/c exposure 150.0 130.0 120.0 110.0 100.0 59.5 139.5 154.5 169.5 204.5 214.5 -127.5 162.0 282.0 267.0 15.0% 13.3% 12.4% 11.5% 10.5% 15.0% 16.3% 17.7% 20.6% 21.3% 15.0% 23.5% 22.5%
03-Jan-00 04-Jan-00 05-Jan-00 06-Jan-00 07-Jan-00 10-Jan-00 11-Jan-00 12-Jan-00 13-Jan-00 14-Jan-00 17-Jan-00 18-Jan-00
So to take a position in the future, you need to deposit 15% of the exposure as initial margin, which is Rs150 in our example. Now after you bought the future contract, it started declining and on 6th January, it closed at Rs950. On this day, the margin account was 10.5% of the current exposure. Till the time your margin account is above 10% of the exposure, your broker will not ask for any extra amount to pay the losses. But on the next day i.e. 7th January, the future closed at Rs930 and the margin account dropped to 8.6% of the exposure on that day, thus bringing on a margin call of Rs59.5 to refill the margin account to 15% of the current exposure at Rs930. After this weekend, your fortunes improved and the future started moving up; on the next Friday, 14th January, it closed at Rs1080. At that point, the balance in your margin account was 26.8% of the exposure at that time. Hence you have a choice of withdrawing Rs127.5 from this account, leaving 15% as the initial margin. So by using simple measures like initial margin and daily margin (mark-to-market), the futures exchange removes any counter party risk from the futures market. And by operating a margin account, the broker makes the transaction in futures very simple.
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Introducing index futures

We saw earlier in the features on the forwards and futures that these instruments allow you to remove the price risk in the market from your investments. This price risk may arise from commodity prices, interest rates (bonds), foreign exchange and also stock prices. All the previous write-ups on futures were applicable to all kind of futures, but from here on we will concentrate on index futures only, our focus being the equity markets. What are Index futures? Index futures are contracts to buy and sell a stock market index at a fixed time in the future at a price agreed upon today. So if the underlying index is the Sensex, then the futures are known as Sensex futures and if the underlying index is Nifty, then they are known as Nifty futures. Index futures are standardised contracts defined by the future exchanges and are trading on these futures exchanges. The standardisation is in terms of the time of expiration and the value of these futures contracts. Expiration and value of futures contracts Both Sensex and Nifty futures have a maximum life of 3 months and, at any point in time, there are 3 series of the index futures trading on the exchanges. The price of the contracts is fixed by defining a contract multiplier, which is 50 for Sensex futures and 200 for Nifty futures. So if you are buying one Sensex future contract at Rs4,000, then the contract size will be Rs4,000 x 50 (contract multiplier of Sensex futures) = Rs2.0lac. Similarly, if you are buying Nifty futures at Rs1,250, then the contract size for the Nifty future will be Rs1,250 x 200 = Rs2.5lac. If index futures have a fixed expiration date, what happens to contracts that are not settled during the life of the index future? All such contracts, which are not settled during the life of the index futures, are settled at the final settlement price. This final settlement price is derived from the average of the last half an hour trading values of the cash market (Sensex/Nifty). No delivery, 100% cash settled The Sensex is composed of 30 stocks, the weightage of each based on the market capitalisation of the stocks. If you sold one future contract, then at the time of expiry you will need to deliver the Sensex, that is, its 30 stocks based on their weight in the index. This delivery of 30 stocks according to their weights in the Sensex could be a cumbersome process, and to avoid all such bother, index futures are settled in cash - profits and losses. If your position in the index future turns in a profit, then you will receive the profit equivalent in cash and if it makes a loss, then you pay the loss in cash. Fixed maturity date makes it a zero sum game An index future contract is struck between a buyer and a seller at a fixed price. The future contract has a fixed maturity date on which all the outstanding contracts get settled at the closing price. So, if the closing price of the index future is above the fixed price, then the buyer of the contract makes money and the seller of the contract loses money. And since the contract is between the two parties, the profit of one is the other's loss, meaning, there is no value created in the system. Hence the index futures are also known as zero sum game instruments. Highly leveraged In the feature on counter party risk, we saw that an investor can take a position in the index futures market by paying an initial margin of just 15% of gross exposure. Also, until your margin account balance is above 10% of
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gross exposure, you don't have to pay any extra money. This 10-15% margin requirement allows you to leverage your money from 6-10 times - that is, you can take an exposure up to 6-10 times of your investment in the market. What is the premium for this facility? There are no free lunches in this financial world; you do need to pay some premium for this leverage facility. But how much premium and how is this calculated? We shall walk down that road in the next of this series - `Pricing of Index Futures'. So keep in close touch with the Sharekhan School to better understand the unique world of index futures and more.
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Pricing of index futures

As we learned in our introduction to index futures, these are contracts to buy and sell a stock market index at a fixed time in the future at a price agreed upon today. Index futures are known as derivative instruments because they derive their value from the underlying index. Taking exposure in Indian equity markets There are two different ways to take an exposure in the Indian equity markets. In the first, you can pay the full amount of the exposure and take delivery of stocks. If you choose to do this, you need to invest 100% of your investment. Or, you could use the carry forward system, where you pay an initial margin (maybe 15*-20% of your desired exposure) while adopting a position and then carry forward this position in the market by paying the badla charge every week. Suppose you want to take a position in the market for 2 months; then, with the first system of 100% investment you have an opportunity cost on your investment. While in the second case of the carry forward system, you need to pay the badla charge, which is, normally, the interest rate ruling in the market. In both cases, you need to pay some financial cost to take a position in the market. The third route - index futures Now with index futures, one has a third way in which to enter the equity market. If you want to take a position for 2 months, you buy index futures with a maturity period of 2 months. Here, you can take a position by paying an initial margin of just 10-15% and no extra cost thereon. You're now wondering if there's some scope for arbitrage between first two options and the third? Sorry, there are no free lunches in the financial markets. The third option actually includes the financial cost in advance. So, if you are buying an index future contract with 2 months to expiration, then you will be paying some premium to the ongoing index value at that time. This premium over the index value is known as the 'cost of carry'. Fair Value of the Sensex Future = Prevailing Sensex Value x Cost of Carry Calculating the cost of carry As we saw above, the only difference between the cash market and the index futures market is the financing cost and therefore the cost of carry should be equal to the financing cost. Cost of Carry = Exp^ (Interest Rate x Time to Maturity) More about Exp But what about the dividend earned on delivery positions? There is no delivery system in index futures; they are settled in cash. If there is any dividend on any of the Sensex stocks during the maturity of the index futures, then this should be adjusted in the index futures value. Suppose you buy an index future contract with 2 months of maturity and during that period the Sensex stocks were expected to give out dividend. You then need to find out the dividend yield based on per contract exposure. The cost of carry becomes: Cost of Carry = Exp {(Interest Rate - Dividend Yield) x Time to Maturity} Do index futures trade exactly at their fair value? The answer is no. The traded value of an index future varies from its fair value, based on the demand and supply of that future contract. But who determines the demand and supply of these index futures? Who are the main participants in this index futures market? Find the answers to these
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questions in our next in this series on index futures! What is this exp? The exponential (exp) function represents 'continuous compounded interest rate'. Consider an amount Rs. 'A' invested for n years at an interest rate of R % per annum. If the rate is compounded once per annum, the final value of the investment is A (1 + R)n If the rate is compounded m times per annum, then final value of the investment is A (1+R/m) mn But if you keep on increasing the frequency of compounding, further then the limit of m tends to infinity. This is known as 'continuous compounding'. In case of this 'Continuous compounding', it can be shown that an amount Rs. 'A' invested for 'n' years at rate of R% p.a. grows to Ae Rn Index futures are settled on the daily basis. In other words, the cost of carry needs to be calculated on a daily compounding basis. Hence, in a year it would get compounded 365 times considering that there are 365 days. As a result, we use exponential function while pricing the index futures.
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Why we need a philosophy to investing When you come to a road crossing, how do you decide which way to take? Do you follow the road signs, look at the map, ask someone for directions, or just go right ahead and take a random shot? If you choose to follow the first option, then you do have a certain philosophy at work. As the Cheshire cat put it so eloquently in Alice in Wonderland: if you don't know where you're going, it doesn't much matter which road you take to get there. Obviously this means that you need to, first and foremost, develop an idea of where you wish to go with your portfolio. No, just "we want to make money" is not enough - a good start maybe, but not enough to qualify as a philosophy! What is an investment philosophy? "An investment philosophy is a set of guidelines by which investment decisions get made. These guidelines help to achieve the well-defined goals of the investor. These guidelines are usually informed by academic findings, actual experience and/or desired investment goals. The important point here is that the investment philosophy represents a set of guidelines and not fixed rules." My Rule No. 1: Think Portfolio When we invest in the equity market, we never think of investing in one single stock. We always look at buying more than one. Many of us buy more than 30. In the course of our practice, we have come across people who own 500 stocks in their portfolio! My Rule No. 2: The objective is diversification of risk You might want to ask us at this point if a portfolio consisting of only 10 (for the sake of argument) steel companies constitutes a good portfolio? No. The portfolio approach calls for diversification. And you do not achieve that when you own a portfolio of just 10 steel companies. The factors that affect the steel business will take their toll on each of the steel companies. Even the market risk does not get spread out. Hence, this portfolio is as risky as one with just one steel company. It fails because there is no diversification across various businesses. An important point to note is that while we advocate diversification - diversification is the means to an end (returns), not an end in itself. My Rule No. 3: Don't spread your net (portfolio) too wide We believe that by casting our net wide across many stocks, at least a few of them will turn out winners. We spread it to decrease risks. However, most investors forget that there is a trade-off between risk and return. As the number of stocks keeps increasing, not only does the portfolio become unmanageable, it begins to reduce your total return. Using a medical parallel, think of it as too many pills resulting in an undesirable side effect! As a rule, WE advocate that the number of stocks in a portfolio never be more than 15 or, at the maximum, 20. Beyond this, it becomes difficult to track so many companies (and they start creating holes in the portfolio). Also, do the arithmetic: if a stock accounts for just 1% of your portfolio and it doubles, your portfolio return goes up by just 1%. Hardly anything to get excited about. My Rule No. 4: Determine your risk profile before creating your portfolio You cannot have low risk and high returns. We hate to disappoint you, but that is the truth. There are no magic wands. You cannot "have your cake and eat it too." A portfolio is always a trade-off between risk and return. Having a portfolio is all about balancing between these two opposite forces. Hence, it is important that you understand your risk profile before creating a portfolio. Portfolio creation is all about optimising returns, given a risk profile and an investment horizon.
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Some final tips Well, that's about it for the rules and philosophy of investment. But before we finish, We would like round off this session with some more words of advice... Recognise your risk profile: Your risk profile is a function of your age, ability to withstand losses, investment horizon (time), existing cash flows (income), past experience and expectations from the market. Risk profiles are unique to every individual and they can only be classified into broad categories to simplify issues. Think "clusters" the way we at Sharekhan do: We have created clusters that stand for certain risk-return profiles. Our Evergreen cluster, for instance, has the lowest risk. The risk increases starting with our Apple Green cluster to our Emerging Star cluster. Ugly Duckling and Cannonball are "quick churn" clusters, again standing for different degrees of risk. Conclusion Seek to build a diversified portfolio, which will double its value every three years. There are going to be bear and bull cycles. It's always going to be difficult, if not impossible, to keep up with those cycles in a bid to make the most of the volatile markets. An investor needs to live out these cycles and survive, for there is no guarantee how long a bear market can last. The idea is for you to last... much longer than it! And only a disciplined philosophical approach to investment will show you
way to that goal.
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You know the basics. Now you are eager to know how to make money. Learn the tricks of being a smart investor. Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 8
Chapter 6: Trader's Handbook Chapter 10: Psychology of Investing
Learn to distribute your eggs in different baskets wisely.

Article 1: Choosing your rainbow | Jun 21 2002 Who knows how long a bear market may last...but you need to...and there's only one way... Article 2: Portfolio diversification | Dec 3 2001 Both husband and wife shouldn't work in dotcoms, after all you need to diversify your risks. Article 3: Diversifying risk | Mar 20 2000 This is what asset allocation is all about.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Portfolio Strategies Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Choosing your rainbow

Why we need a philosophy to investing When you come to a road crossing, how do you decide which way to take? Do you follow the road signs, look at the map, ask someone for directions, or just go right ahead and take a random shot? If you choose to follow the first option, then you do have a certain philosophy at work. As the Cheshire cat put it so eloquently in Alice in Wonderland: if you don't know where you're going, it doesn't much matter which road you take to get there. Obviously this means that you need to, first and foremost, develop an idea of where you wish to go with your portfolio. No, just "we want to make money" is not enough - a good start maybe, but not enough to qualify as a philosophy! What is an investment philosophy? "An investment philosophy is a set of guidelines by which investment decisions get made. These guidelines help to achieve the well-defined goals of the investor. These guidelines are usually informed by academic findings, actual experience and/or desired investment goals. The important point here is that the investment philosophy represents a set of guidelines and not fixed rules." My Rule No. 1: Think Portfolio When we invest in the equity market, we never think of investing in one single stock. We always look at buying more than one. Many of us buy more than 30. In the course of our practice, we have come across people who own 500 stocks in their portfolio! My Rule No. 2: The objective is diversification of risk You might want to ask us at this point if a portfolio consisting of only 10 (for the sake of argument) steel companies constitutes a good portfolio? No. The portfolio approach calls for diversification. And you do not achieve that when you own a portfolio of just 10 steel companies. The factors that affect the steel business will take their toll on each of the steel companies. Even the market risk does not get spread out. Hence, this portfolio is as risky as one with just one steel company. It fails because there is no diversification across various businesses. An important point to note is that while we advocate diversification - diversification is the means to an end (returns), not an end in itself. My Rule No. 3: Don't spread your net (portfolio) too wide We believe that by casting our net wide across many stocks, at least a few of them will turn out winners. We spread it to decrease risks. However, most investors forget that there is a trade-off between risk and return. As the number of stocks keeps increasing, not only does the portfolio become unmanageable, it begins to reduce your total return. Using a medical parallel, think of it as too many pills resulting in an undesirable side effect! As a rule, WE advocate that the number of stocks in a portfolio never be more than 15 or, at the maximum, 20. Beyond this, it becomes difficult to track so many companies (and they start creating holes in the portfolio). Also, do the arithmetic: if a stock accounts for just 1% of your portfolio and it doubles, your portfolio return goes up by just 1%. Hardly anything to get excited about. My Rule No. 4: Determine your risk profile before creating your portfolio You cannot have low risk and high returns. We hate to disappoint you, but that is the truth. There are no magic wands. You cannot "have your cake and eat it too." A portfolio is always a trade-off between risk and return. Having a portfolio is all about balancing between these two opposite forces. Hence, it is important that you understand your risk profile before creating a portfolio. Portfolio creation is all about optimising returns, given a risk profile and an investment horizon.
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Some final tips Well, that's about it for the rules and philosophy of investment. But before we finish, We would like round off this session with some more words of advice... Recognise your risk profile: Your risk profile is a function of your age, ability to withstand losses, investment horizon (time), existing cash flows (income), past experience and expectations from the market. Risk profiles are unique to every individual and they can only be classified into broad categories to simplify issues. Conclusion Seek to build a diversified portfolio, which will double its value every three years. There are going to be bear and bull cycles. It's always going to be difficult, if not impossible, to keep up with those cycles in a bid to make the most of the volatile markets. An investor needs to live out these cycles and survive, for there is no guarantee how long a bear market can last. The idea is for you to last... much longer than it! And only a disciplined philosophical approach to investment will show you way to that goal.
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Portfolio diversification
Why I avoid working with my better half in the same company ... and this has nothing to do with the fact that I could not then flirt with all the beautiful girls in my office . Nor does it have anything to do with being my own master - eating at will, having as much coffee as I please, going to all those late office parties, etc. I work with a company operating in the dotcom space and my wife works as a jewellery designer. So what am I doing here, recounting to you my family CV? Well-l-l-l... because, you see, it all comes down to reducing the element of risk in our lives and the streams of income that support it - and sharing office space with our spouse would hardly contribute to that cause, would it? Remember the 'oft repeated advice our elders and betters always gave us - "don't put all your eggs in one basket?" Same principle applies to stocks Obviously we complicate our lives so in order to spread our risks - life is unpredictable enough as it is! And the same principle applies in other spheres of life, eggs, jobs, or investments. Wisdom says that you should not risk everything you have on the success of one plan. More pertinently, you shouldn't put all your money into one business. Extending the principle to investment, it follows that it must also not be advisable to put all your money into one stock. No, not even if it's a winner like Infosys. In other words, the one who has a diversified portfolio stands a better chance of surviving carnage in the market than the one who puts all his bread in one or a few stocks. And that brings us to our topic of discussion - portfolio diversification. FAQ How can you tell if there's enough diversification in a portfolio? Are there a certain number of stocks to shoot for? Or certain industries that should be represented? What's the best approach to take? Most portfolios begin with the purchase of a single stock. It isn't until sometime later that thought goes into the building of a diverse portfolio. Perhaps the first thing to consider in building a portfolio is that it is not necessary to own a stock in every industry. There are over 125 different industry classifications that one can have in the Indian context and I'm pretty sure that any personal portfolio should not have that many stocks! There are a great many investors who follow the industry approach to investing, the idea being to find a promising industry with well-defined growth potential and then to buy a stock in that industry that appears to be reasonably priced and with the best record. There's nothing wrong with that approach as long as the investor doesn't become, what should we say, a trend chaser. But isn't the software sector too good to miss? Too many times, we hear that an industry, say biotechnology or software, has a bright future. That makes some investors think that they have to have a biotechnology or software stock in their portfolio. They end up buying one, regardless of what its financials are like. The future is not guaranteed for any company just because it operates in a particular industry that has a strong growth potential. It still comes down to the quality of management and how effectively the management team can direct the future of the company. Overdependence on one sector, however hot, is not a good idea The reason for diversification is to spread the risk. Overdependence on any one industry can hurt a portfolio's performance if there is some bad news about that industry. It has been my experience that all the stocks in a particular industry may decline when there is some bad news about the future of just one of the companies that can be traced to an industry problem. Take for instance Infosys, Satyam and Aftek, all three of which were commonly held in the same
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portfolio because of their superior growth records. But this turned out to be a big mistake when all infotech stocks plummeted over the past 6 months. Just think, I even knew some guys whose portfolios had as much as 90% of assets in software alone! Infosys Vs BSE Sensex-
ShareKhan IT Index Vs BSE Sensex-
The magic number: 20 and no more That brings us to the percentage of the portfolio that should be in any one stock or industry. There may not be an exact answer, but in a large portfolio, a prudent approach might be to have no more than 20% of the portfolio's total value in one single stock. As a portfolio is being built, that percentage might go as high as 25%. At the same time, I don't think there should be a formula to sell stocks just because they have performed well and exceed the said guidelines. For a sectoral breakdown, one would ideally not allocate over 35% to one single sector or segment of the industry. This would ensure that the fads of the market don't undermine the long-term portfolio. For example, an investor can have 15% of his portfolio in a particular stock and because it performs well, may find that the percentage grows to 25%. Some investors feel a portion should be sold so that there won't be overdependence on that one stock. While this could work for some, for others, the approach is to add to the other holdings to bring the percentages more in line with the target percentage holding. Otherwise, you may find that you are selling the winners and are left with those stocks that may not perform as well. This is something that the Hammock will need to tackle soon Invest as much as you understand... I am not sure if there is an exact answer to how many stocks a portfolio should hold. An aggressive investor may be comfortable with only a few, while others may want to spread the risk over 20 or 25 different stocks. My feel is that the number of stocks in your portfolio is directly linked to how many stocks you can manage to handle and understand. After all, you are buying into businesses and you need to understand them, at least somewhat. I recommend that somewhere around 15 well-chosen stocks should bring you most of the benefit there is to gain through diversification. In a nutshell "Don't put all your eggs in one basket." Good advice like no other. When it comes to investing, diversification - putting your money into a variety of stocks that have different return potentials and risk levels - means not putting all your eggs into one investment basket. Since market cycles vary, diversification will allow you to offset possible losses in one investment with potential gains in another and, as a result, help reduce your overall exposure to risk. So, from now on, every morning when you wake up and look in the mirror, ask yourself this: Have I diversified my portfolio today?
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Diversifying risk
You must have encountered this term many times. In fact, we talked about asset allocation as a means to come to terms with volatility. We all understand that where we put our money has an impact on the profits we make. Imagine being invested 100% in software stocks in 1999 and 100% in bonds in 2000 probably have given an arm and leg to have got that 'asset allocation'.
J, all of us would
Spare a moment here to think if one was 100% invested in bonds in 1999 and 100% in software stocks in 2000
All of us never keep all our investments in one class of assets like gold, real estate, bonds, stocks or cash. It is always distributed across these asset classes. We do it to spread risk obviously. This is what asset allocation is all about. The need to diversify Take a look at our earlier example. On hindsight, may be it made sense to have 50% in software stocks and 50% in bonds during 1999 and 2000. That way one would have compensated for another. Essentially, one would have diversified risk and may be settled for a potentially lesser profit. But then it means two years of more peaceful sleep. Hence, investors not only diversify across various stocks but also various asset classes. Since we are talking about assets, it helps to understand the classification of assets. Normally assets are classified into three categories
Real estate, gold, stocks: Uncertain returns (these bear price risk) Bonds: Certain returns (fixed income securities like deposits held till maturity) Cash: No returns
While asset allocation is a simple concept to understand, the tricky part is to figure out how much money to put where. We are all different people with different risk profiles. Hence there can be no one rule that fits all. However, there are some empirical rules. Let's take the example of readymade trousers based on waist size and length. Incidentally, there is a rule for the ideal weight for a person. The ideal weight for a man (kgs) is meant to be his height (cms) minus 100 where as for a woman it is her height minus 110. The "Rule of 110" Similarly, there is an empirical rule for asset allocation called the "Rule of 110". Subtract your age from 110 and that in percentage should be the proportion of your assets in stocks. In other words, if you happen to be 30 years of age, you should have (110-30) 80% of your assets in stocks. So when you are 60 years of age you will have 50% of your assets in stocks.
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But what if at 60 years of age you are very healthy, your children are very well off and you have no financial responsibilities? Then may be you could look at having a higher than 50% exposure to stocks. But the caveat is that you would be assuming higher risks. Keep the thumb rule in mind Remember, this is just a thumb rule and not a patthar ki lakir (something which cannot be overruled). Just like everyman who is 180cms tall does not necessarily weigh 80kgs
Whenever you don't follow the thumb rule of asset allocation, be aware about the risk profile you have created. Allocating more than what the thumb rule says to stocks is assuming a higher risk whereas anything below the limit would mean assuming lesser risk and hence settling for lower returns.
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You know the basics. Now you are eager to know how to make money. Learn the tricks of being a smart investor. Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 9
Chapter 6: Trader's Handbook Chapter 10: Psychology of Investing
Learn to spot a winner

Article 1: The world outside the well | Jan 8 2001 Judge a good business by the company it keeps! Article 2: Businesses that make good stocks | Aug 13 2001 Good businesses make great stocks, there is more to this truth...
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Essentials of stock picking Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
The world outside the well

The trend on trends You must have heard analysts on CNBC talk about business trends. What is that about and how do they help gauge a company's health? Don't financial ratios determine whether the company is in good financial health, and measure all parameters of company efficiency, besides tracking their growth? We have seen the entire gamut of basic ratios that value businesses book value, EPS, PE, RoE, RoCE - and their relevance to stockpicking. But while that helps in valuing the financial health of the company, there is still a lot more that goes into buying a good company. There are factors prevailing in the environment that determine profitability and growth. Which is why the study of trends comes in. Let us take a look at business environments in the next few paragraphs. Our objective is to suggest which factors to look for while picking a successful business. How not to believe everything you see. Financial ratios follow good business trends, i.e. they happen after the business cycle. Being alert to and using external trends "Despite the management's continuing effort to improve efficiency and control cost, and achieving higher throughput, the operating profit before depreciation, interest and tax had gone down by 18%. This was mainly due to the decline in net sales realisation as a result of very competitive conditions prevailing in the market." - Directors Report, ACC for FY2000. What went right? The efficiency of the manufacturing business improved. All internal factors that could result in cost saving were implemented. This ideally should have led to a higher profit margin. Did this happen? No. While the company was cutting its costs, the sale price of the final product came down because of competitive (external) pressures. The business was in a state of oversupply, which was pushing down selling prices and reducing profits. ACC - March 99 - April 00 chart
But does the reverse hold true? Let's look at the not so long ago evergreen sector, technology (or software, if you prefer). Two of India's premier companies in the tech sector are talking in forked tongues, although they operate in practically identical businesses. Says the Director's Report, FY2000, of Infosys: "The Indian software exports industry demonstrated healthy growth during the year. The year saw your company winding down its year 2000-related engagements, in line with its risk management strategy. Your company has successfully managed the transition of its year-2000 related work." Goes Tata Infotech's Director's Report for FY2000: "During the same
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period, year 2000 services revenue also declined sharply." The latter reported a profit of Rs12.12cr, a fall of 65% over the previous year, while Infosys reported a 125% growth in profit. How do these two cases correlate? Well, both operate in the same environment and the same industry. Infy v/s Tata Infotech - 2 year price performance
Controllable vs. not controllable With ACC, the downfall in profit was due to external factors, something companies rarely are able to influence, rather than internal factors such as cost saving, which it dutifully took care of to no avail. In contrast, Infosys had external factors on its side - spends in tech worldwide were booming - and it rode the trends well. The management was farsighted and did not look just at building profitability on near term opportunities like, say, Tata Infotech did. Tata Infotech is a case of how a company despite a booming environment can falter by not being alert to trends forming in the industry. How business environment affects companies An environment builds the platform on which a company survives and grows; it has to be supportive to the business's growth. Not too many companies can continue to grow when their economic environments are clouding over. The basic economic factors hold true while looking for a business to invest in. Does the demand-supply equation favour the company's operation to be viable and make money? Of course, that is the idealistic scenario, but the viability of the business centres on the broad parameters of demand and supply in the industry.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Essentials of stock picking Advanced Investing - Tips and Tricks Chapter 1: The Nature of the Market Chapter 4: More on Valuing equities Chapter 7: Futures and Options Chapter 10: Psychology of Investing Chapter 2: Understanding Markets Better Chapter 5: Investing Styles Chapter 8: Portfolio Strategies Chapter 3: Investment Strategies Chapter 6: Trader's Handbook Chapter 9: Essentials of stock picking
Businesses that make good stocks

The secret to that lies in the answer to this question: what makes successful businesses? Of course successful business are those that can earn money. The following factors may shed some light on whether the business in question is making money? Business continuity First, look at continuity of business. Take the instance of Tata Infotech. While the entire technology sector in India was thriving on the Y2K solutions business, this company overfocussed on this area and failed to reinvent its skills to fit into a post-Y2K scenario. The outcome is there for all to see in the stock price. Although it brought in the bread in the initial years, the orders dried out towards the end, as they inevitably would. Continuity in growth was broken. Take the example of a company in the electronics sector. The Indian government-owned EcTV closed down operations when it failed to take advantage of other business opportunities. It was once the largest seller of television sets in the country. Another example in this industry was Videocon VCR, which was set up as a standalone manufacturer of VCRs. The company failed to be alert to technological advancements, which sounded the death knell for the outdated VCR, and obviously for the company too! Adequate capacity Second, look at capacity. How big is beautiful? Size brings in economics of scale all right - costs are spread over a larger output, bringing down cost. But bigger isn't necessarily better in this case. Companies can grow out of control. Arvind Mills built 10% of the global denim capacity, creating an oversupply situation. When these capacities went on stream, prices of denim dropped and the infrastructure costs just killed the company. Arvind couldn't go close to achieving full capacity in its manufacture, which it needed to do to be viable. Something similar happened to Core Healthcare. The company scaled up its capacities to 60% of India's IV fluids capacity. The market just could not absorb this capacity and its quality was found wanting in the international market. The obvious happened: losses mounted and the company completely eroded its net worth. Big could also mean small, but dominant in its area. Small companies in niche segments which nevertheless rule their sectors. Like Himatsingka Siede, a designer house that is making it big in the international silk furnishing business, catering to a select market and never going in for overkill.
Capacity as much as the market needs, not how much the company can make
Survival ability Competition kills and this is one major cause of failure. Hindustan Lever has over the years taken the competition to its rivals and expanded its portfolio. When growth from its bread and butter business of detergents and soap was plateauing, the company found new outlets to grow. In the last two decades, this survival skill transformed HLL into an FMCG conglomerate with powerful cash flows. The survival factors here are more to do with the ability of the management to see future trends in their business. Subsidies and barriers to entry
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In numerous cases, to encourage the development of a business or of society, governments resort to subsidising services and equipment in order to make it viable for manufacturers to develop infrastructure. But such sops-dependent businesses may not make for wise long-term investments. Once such benefits are withdrawn, as they must eventually be, companies are exposed to the cold chill of ruthless competition, which may squeeze margins and reduce cash flows. Monopolies also bring with them inefficiencies that are hard to scale back in a free regime. An apt example is MTNL, a public sector telecom unit that in the last few quarters has been struggling to maintain its profitability and market share. Talking about subsidised businesses, Renewable Energy Systems and NEPC Micon are two companies that actually thrived on subsidies to grow their profits. That's all they did. In a crunch, when subsidies were withdrawn, they found themselves uneconomical and unviable because their products weren't as efficient as alternatives available in the market. The markets have recognised these factors at the earlier stages and valued these companies at a meagre 10 times their earnings.
Monopolies and subsidised business come with a disclaimer: though cash flows are strong, returns will exist only as long as the happy situation does
Minor points to watch, from the company's viewpoint Appropriate infrastructure: The infrastructure should complement the market where it sells its product or where it procures its raw material. You can't have a cement plant in Karnataka and try to service the Delhi market. It would be far more expensive just to transport goods that far, thus spiralling costs.
Watch competition
New capacity creations: Most capacities in any business come in at the peak of the business cycle. This generally leads to a drop in selling prices as new capacities mean more supply. And a demand drop would hurt the players in that field.
Increase in capacities usually comes at the crest of the product cycle

Cost management: The company should have a suitable cost structure for the business. Lower costs enable the company to survive in a down phase well. In an upward business cycle, good cost management implies higher profitability.
Efficient companies go the distance. In an industry revival, these are the first to rebound
Products with stamina: Look out for opportunistic businesses. There have been small niche players who have tried to identify and milk insubstantial opportunities. For instance, a small company, India Food Fermentations, tried to market the concept of dosas as fast food through a vending machine, Dosa King. This company went bankrupt.
Novelties don't make lasting businesses

The above factors were about as comprehensive as we could cover them. These are, broadly, the most common factors one encounters as an analyst in the process of sieving out companies eligible for investment. The important factors we plan to cover in these series are on management, valuation, and constructing forward-looking financial statements. More later, then!
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns More on Investing
More on Investing scheme
If your dil maange more, check out this section for various articles on investing in stocks. Happy reading! Chapter 1: On Stocks Chapter 2: On Stock Markets Chapter 3: The rest
Chapter 1
Chapter 1: On Stocks
Demat? Book Building?? Buy Back??? Article 1: Yeh dematshemat kya hai | Nov 5 2002 Dematerialisation--the word has been an enigma to most. Article 2: Book building tomorrows IPOs | Jun 14 2000 Book building aims to arrive at a price based on demand. Heres how it is done... Article 3: Stock buybacks | Sep 13 2002 Why do investors love it when the company wants to buy its shares back from them? Article 4: About stock splits | Sep 17 2002 A stock split does not change a company's fundamentals. Then why does the stock price rise? Article 5: Of defensives and cyclicals | Sep 20 2002 HLL is oft called a defensive stock and Reliance a cyclical. What is the difference? Article 6: Everything about bonus... | Jan 4 2001 ...that lets you make no bones about it.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Let's get the formal definition out of the way. Dematerialisation is the process by which your holding of physical share certificates is converted into an electronic record. What that means is that just as a bank holds your money in a savings account, the record of your share holdings is held by an institution called a depository. But why on earth would I want to exchange my physical share certificates for an electronic record? For some very obvious reasons. How many times have you worried about the thousand things that could go wrong while transferring shares in your name? How many nightmares have you had imagining the theft of your share certificates? Or, their getting burnt or lost? Second, whenever you have read in the newspapers about forged and fake certificates, you'll admit that you've wondered if some of the ones you hold and have yet to get transferred are fake as well. Haven't you cursed the whole chore of sending your certificates by post to the company's registered office for transfer? How many times have they been returned with the terse remark -- "Objection". Dematerialisation, or demat for short, is the magic wand that drives away all these worries. How? Demat shares are an electronic record, so there's no question of their being fake. Nor need you worry about bad deliveries. There is no physical share certificate and hence no need to find a safe place to keep it under lock and key. I am still not convinced! There are other good reasons for demat. The introduction of dematerialisation has also allowed us to dispense with the concept of marketable lot-even one share can be bought or sold. In the old world of physical certificates, typically shares could be traded only in lots of 100. Demat is great for small investors, as it enables them to buy even shares with high rupee prices. It also gets rid of the problems relating to odd lots that typically trade at a discount. Next, bonus/rights shares allotted to you can now be immediately credited to your account-no problems of getting the scrips through the post, the certificates getting lost, etc. And what's more, you can receive the statement of account of your transactions/holdings periodically, just like a bank statement. So, how does one dematerialise shares? Convinced about the arguments in favour of dematerialisation? The next step is to know how to go about it. You'll have to approach a depository participant (DP), who is usually a broker or a banker, to open an account. You cannot directly approach the depository, whose role is something akin to that of the RBI-so only depository participants (DPs) have accounts with them. What are the various steps involved? Start by getting a list of DPs-your broker will be only too happy to oblige. The DP is your link with the depository. Next, submit a request to the DP in the dematerialisation request form for dematerialisation along with the certificates of the companies to be dematerialised. Before submission, you have to deface the certificates by writing "SURRENDERED FOR DEMATERIALISATION" on them. The DP will issue you an acknowledgement slip duly signed and stamped. When the issuing company or its registrar confirms accepting the request for dematerialisation, your account will be credited automatically. It's as simple as that. What happens to my share certificates? Dematerialisation, as you can see, is therefore the process in which your physical share certificates are first taken back by the company, or its registrar, and actually destroyed. Then, an equivalent number of securities are credited in your electronic form to your account. The process should take around 15 days. One important point-the shares have to be in your name before they are sent for dematerialisation. So, what IS dematerialisation? Dematerialisation is an ugly word. Apart from its polysyllables, it conjures up scary visions of your share certificates dissolving into thin air. Nothing, however, could be further from the truth. As a matter of fact, dematerialisation is one of the best things that could happen to your share holdings. On Stocks More on Investing - scheme Chapter 1: On Stocks Chapter 2: On Stock Markets Chapter 3: The rest
Yeh demat-shemat kya hai
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What if I want my share certificates back? For those conservative souls who want to be able to keep the way back open, just in case, there's always rematerialisation. If, for some unaccountable reason, the urge to hold paper overwhelms you, you can go in for rematerialisation, where the shares will be converted from the electronic to the paper form. In that case, your DP will forward your rematerialisation request to the depository, after verifying whether you have the necessary securities balance. The depository, in turn, will inform the registrar, who will print the certificates, and despatch them to you. This should take about a month. Will I need the services of a broker? You'll notice that the depository is the securities bank, and the DPs are its branches. Just like a bank, your DP will give you a passbook, or a statement of holdings. There is no restriction on the number of DPs you can open accounts with. However, as in the physical segment, all your trading will have to be channeled through a broker. And while buying or selling shares, you must provide your broker with your account number, and your DP's identification number. Is dematerialisation expensive? Not really. Stamp duty has been waived completely to make share-transfers in the dematerialised segment more cost-effective. In the physical segment, the stamp duty is 0.50 per cent of the market value of the shares transferred. As for the custodial fees, they range between 0.05 per cent and 0.10 per cent, and vary between DPs. Yes, you'll argue that while physically holding shares, you don't pay custody charges at all. Moreover, in the demat segment, you have to pay the annual service charges even if there are no securities in your account. And DPs will charge around Rs 2 to Rs 5 per share certificate for dematerialisation. Some DPs also charge for opening and closing accounts. But consider the advantages. A depository relieves you of the bother of sending your shares for transfer, and saves you the postal and courier charges. Demat's the way shares are going to be in the future. Is trading in demat shares time-consuming? On the contrary, buying and selling in the demat mode can potentially be much faster. For dematerialised shares, the exchanges have an additional trading segment known as the rolling settlement (T+5). What this means is that all trades executed on a particular day (T) will be settled by the following fifth (T+5) working day. When you buy shares in the demat mode, you become the owner of those shares in the electronic form within a day of the completion of the settlement. Similarly, when you sell shares in the electronic form, you receive the payment much faster. Any other advantages? Sure. When you buy/sell shares in demat, all you have to do is that, after confirmation of the purchase/sale by your broker, you should approach your DP with a request to debit or credit your account, as the case may be, for the transaction. Your account will immediately be updated. The biggest advantage of demat is that it has resulted in a drop in transaction fees charged by brokers. Why? Because their hassles and the risk of shares turning out to be objectionable, fake, forged, etc. are vastly reduced. As you might have noticed, the whole depository and demat business, despite the forbidding jargon, is just like operating a bank account where shares, instead of money, is kept.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page On Stocks More on Investing - scheme Chapter 1: On Stocks Chapter 2: On Stock Markets Chapter 3: The rest
Book building tomorrows IPOs

Bookbuilding: in the spotlight You'll have read about the thumping success of the Hughes Software issue. You'll also have noticed the pink newspapers going ga ga over the success of what they call "the country's first issue through the bookbuilding route". What exactly does bookbuilding mean? How is it related to an issue? These questions are important because bookbuilding could be the future of public issues in India. It is the way in which new issues are marketed in the developed countries. Now that Sebi has allowed the bookbuilding method to be used for issues above Rs100cr, and looking at the large premium that Hughes Software has been able to get, it may well be the future mode of issues here as well. But what does it mean? Let's take a look at the issues (no pun intended) involved. The basic difference between book building and an offer through the normal retail route is that in bookbuilding the price at which the issue is done is determined based on the demand received. In the conventional public issue the price is decided first and then the stock is offered to investors. "Price is determined based on demand". Sounds complex? Here's how it's done Let me explain. A company going public approaches its lead manager, who's an investment (merchant) banker. Often the lead manager is actually a consortium, or a group of investment bankers, which helps spread the risks. The company specifies the amount of shares on offer, and collaborates with the lead manager in drawing up the offer document. No price is set in this document. Instead, a price band is shown, merely to indicate the likely price. The document, which is called the prospectus, is then filed with the regulator, such as Sebi, which gives it a legal standing. The lead manager, also known as the underwriter, (because he gives a commitment to the issuer on the entire or part of the funds the issuer is trying to raise at a certain floor price) is responsible for errors in the prospectus. In the US, lawsuits take place if the prospectus is untruthful, and the damages awarded are large enough to ensure that the underwriter has a strong incentive to provide the correct information. The lead manager is promised a fee for marketing the issue, which is typically a percentage of the proceeds of the issue. This ensures his incentive to obtain as high a price as possible for the issue. Determining the investors' demand function The lead manager now invites investors he knows into the initial public
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offering (IPO) process. These are institutional investors, and participation is by invitation only. In India, however, Sebi allows retail investors to be part of the process. The issue manager asks each investor for the number of shares he would buy and the price at which he would buy. This is known as the investors' demand function. But wouldn't the investor quote a lower price? Yes, it is in his interests to quote lower, but he would balance that against the fear that he wouldn't get the number of shares he asked for. After all, the process is like an auction, the difference being that he doesn't know what price the others are offering. Getting to the market-clearing price Only the lead manager knows the demand function of all the bidders. Based on these bids privately revealed to him, the underwriter comes up with a final price, which is the highest price at which the entire lot on offer can be sold. This is known as the market-clearing price. Once the price is established, and the company making the IPO agrees to it, the underwriter has a good deal of flexibility in deciding exactly how the shares are to be allocated amongst the various investors. That's another check on the investors' playing fair in the bookbuilding process. In practice, relationships between investors and merchant bankers have been built up over time, and investors know that any hanky panky will result in their not getting a decent share in the future. Finally, the shares are allotted, and listed on the stock exchange. It is here that one of the most interesting parts of the bookbuilding process begins. The underwriter or lead manager puts in a limit order to Buy on the exchange at the offer price of the IPO. What this means is that he will be open to buying back any amount of the shares on offer at the price of the IPO. This order stays open for roughly a week. This is called price stabilisation. The idea behind this requirement is to force the lead manager to disclose the right price and set a benchmark price at which there are no sellers. A superior alternative to traditional IPO process In India, the current long process of tapping individual investors leads to delays in the IPO process as well as under-pricing. Currently, it takes more than a month to get over the entire process of making a primary issue. Thousands of individual investors take part in the process, and the paperwork involved is horrendous. These retail investors are unable to distinguish good issues from bad ones. This results in their fear of paying too high a price, leading to under-pricing across the board. In retail IPOs, companies, and merchant bankers, are actually catering to the least informed investor. Bookbuilding, which arrives at a consensus price by informed investors, is a better way of accurately judging a company's potential and the price of its scrip. But more clarity on rules is needed In India, an earlier attempt at bookbuilding by Nirma had fizzled out, and the Hughes Software issue was the first successful attempt. One notable feature has been that the price discovered through bookbuilding is then used for an IPO using the retail route. Sebi rules currently say 10% of the entire issue must be offered to retail investors in this way. This ensures that retail investors are not shut out of the market. However, many of the rules are still hazy, and the responsibility of the lead manager in supporting the market post-issue, does not seem to be well realised. But success breeds success. Investment bankers, investors and regulators will all learn by experience, and India, like the rest of the world, will ultimately go the bookbuilding way.
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Stock buy-backs
What is a buyback? A stock buyback is exactly what it says it is-a company buying back its own shares. Investors love it. For several reasons. First, a buyback, to be effective, has to be at more than market value. So investors gain. Second, the announcement of a buyback is enough to send the stock up in the market, so investors gain again. Third, a buyback announcement is a very strong signal from the company management that they believe the market has underpriced its stocks. It is a chest-thumping way of saying that we're better than what the market thinks. Four, stock buyback effectively sets a floor for the scrip. It's like the management saying--Look, this is what we think our price should be, and we'll buy if it goes below that. Five, stock buybacks increase earnings per share, which is nothing but the net profit divided by the number of shares. Since the number of shares comes down in a buyback, the EPS obviously rises. Six, these days many companies offer stock options to their employees, which is nothing but the right to buy stock at a certain price at a certain time. The effect is to dilute equity, that is increase the number of shares, which means a lower EPS. A buyback counters the effect of this dilution. Restrictions are blamed for the paucity of buybacks in India Sounds too good to be true? No wonder market bulls kept on telling the finance ministry that the absence of share buybacks was what contributed to the bear market. Well, buybacks have since been allowed in India, but few companies have come forward with buyback plans. Marketmen now say that the restrictions that hedge in buybacks are too severe. For example, all shares that are bought back will have to be extinguished, which means they can't be issued again. If this restriction wasn't there, companies could buy their own shares when they are underpriced and sell them when they're overpriced, making a tidy profit. The counter-argument, of course, is that managements would abuse their position, using insider information to manipulate share prices. And secondly, companies that go for buyback have restrictions on tapping the market for more funds. Small wonder that companies are not too keen on buybacks. But that's not the real reason Note that the real reason could be very different. At a time when share prices are down it makes sense for company managements to signal the intrinsic price (at which they believe it should trade) of their shares by announcing a buyback when the scrip goes below that price. When prices are quoting at very high valuations, company managements are reluctant to offer buybacks at high prices. Why is that? Because the real question should be: is a stock buyback the best use for the company's money? In other words, could the company have received a higher rate of return if it had invested that money in some other asset besides its own stock? Analysts say there's a simple way to find that out. Buyback should depend on intrinsic value of a stock This is what an analyst has to tell company management. "The rule is to buy back stocks is that as long as you are buying your stock for less than its intrinsic value, you are creating more value for shareholders. Intrinsic value is what a stock is worth, based not on temporary stockmarket bullishness or bearishness, but on the business prospects of the company. The moment you start paying a premium to buy back your stock, you are destroying value. You will then be using company money to buy an asset which is going to lower your rate of return." Of course, there may be differences about what a company's share is intrinsically worth. Nevertheless, it can be said that in bull markets, when values are inflated, it doesn't make much sense to go in for buybacks. It's the same as using shareholder money to buy an asset at an artificially high price, thus losing money in the process. ROCE is a good indicator The simplest benchmark one can use to see if a buyback adds value is to compare the ROCE (Return on Capital Employed) of the company with its cost of debt. If a company has a ROCE in excess of its cost of debt, it makes sense for the company to take on debt and buy back its equity. This is neither a sufficient
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condition in itself or for that matter a necessary condition. But ignoring all other factors for the moment this is the best criterion to judge if a buyback adds value or not.
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About stock splits

Investors must have read a lot on stock splits in newspapers of late. There have been several stock splits in recent times. Not to mention the spiralling stock prices due to stock splits. Ever wondered what actually does a stock split do? A faintly similar thing is bonus. How does that work? In theory, a stock split shouldn't affect market capitalisation Let us take the stock split of Infosys as an example. The company split its share into two. If the pre-split price of a share is Rs10, and the stock is split two for one, then, theoretically speaking, the price of the new (split) share should be Rs5. That's because the company's net assets do not increase, only the amount of its outstanding shares goes up. But life is vastly more complicated than theory. In the Infosys' stock split, the market was expecting five shares for one; the two-for-one ratio disappointed it and the stock plummeted after the split was declared. Theoretically, a stock split is a non-event. The fraction of the company that each share represents is reduced, but each stockholder is given enough shares so that his or her total fraction of the company owned, remains the same. The split should not change market capitalisation. But it often improves sentiment for the stock In practice, however, market cap does change. A split often drives the new price per share up, as more of the investing public is attracted by the lower price. A company might split when it feels its share's price has risen beyond what an individual investor is willing to pay, especially when the shares are bought and sold in marketable lots. Even when the shares are traded in the demat mode, where even one share may be traded, the price may be high enough to discourage small investors. A shining example is Infosys again. The stock was trading at almost Rs10,000 prior to its split. (Of course, it has almost doubled since then, and is quoting at the same level post-split! But that is a different story). It attracts small investors and increases liquidity Another reason frequently offered for a stock split is that it increases liquidity. Because the number of shares increases, the amount that investors are willing to buy or sell also goes up. For instance, an investor may be willing to buy one share of Rs5000, but may not venture if the share price is Rs10,000. Companies sometimes want to attract individuals to stabilise the price, as institutional investors buy and sell more often than individuals. That's yet another reason for a split. What about bonus? Bonuses have a long history in India. A bonus is nothing but capitalisation of the issuing company's free reserves. If a company has a capital of Rs100, and reserves of Rs100, it can issue bonus shares of Rs100. In its balance sheet, the company's capital will then (post-bonus) be Rs200, while reserves will be nil. The net worth of the company will not have changed in any way. So, here too, the price of the single share should diminish, depending upon the bonus ratio. Again, in practice, a bonus issue is a way of the company to reward its shareholders. It is also a sign that the company is healthy. That's because while nothing may have changed for the shareholder, the company has the responsibility of servicing the new shares.
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Of defensives and cyclicals

Cyclicals and defensives are possibly some of the more frequently used terms (or is it jargon?) in the stock market. Ever wondered what these mean? And why are these called so? Stocks are sometimes divided into two broad categories - defensives and cyclicals. The dividing criterion is a stock's response to business cycles. So, to understand which stock is defensive and which is cyclical, we will first have to know what is a business cycle. It is well-known phenomenon that while an economy grows over a period of time, this growth is far from smooth. At the same time, the trend is not hopelessly jumbled or random. What is striking is that growth seems to occur in cycles, usually well-defined cycles. Economy moves in cycles... Take the start of an upturn. Business picks up, orders increase, demand increases and piled-up inventories start getting run down. The climate slowly improves till sales growth zooms, profits follow, and all the capacity in the economy gets used up. That's the time when demand for investment picks up. New factories start getting built, new machinery start getting ordered. At this stage of the cycle, business is booming. And the cycle repeats... The over-optimism results in too much capacity being built up. Demand fails to keep pace with the supply of goods and services. The high costs of new equipment and new capital expenditure weighs on companies. Profits start getting squeezed and the downturn in business activity starts. Soon, the rate of growth of profit contracts, business sentiment is dampened, excess capacity is widely prevalent in industry, there are job losses, and demand shrinks. This is recession, and business continues to remain depressed until the next upturn. Why do business cycles occur? Economists have advanced several reasons. Among the most convincing is the one advanced by Lord Keynes: that there is no stabilising mechanism in economy that equates savings to investment. That's because those who save are not necessarily those who invest. So, there'll always be a gap between savings and investment. For instance, if there's too much savings, then not enough will be spent on consumption, and demand will suffer. He said that the government must step in to increase effective demand when there is excess capacity in the economy. Many companies have fortunes linked to these cycles There are industries that are cyclical. A very high sensitivity to the business cycle is what distinguishes them. For instance, commodity prices move up with the cycle and down with the cycle. That's pretty obvious, because the demand will depend on the level of business activity. So, all commodity stocks are cyclicals. Or take the banking sector, which is a clear play on the economy. Banking profits depend very much on the level of business activity in the country. Banking stocks are very cyclical. Companies selling luxury goods, such as diamonds, are also very much affected by the state of the economy. A select few escape the cycles All companies are affected to a greater or lesser degree by business cycles. Those that are relatively insulated are known as the defensives. For instance, fast moving consumer goods (FMCG) companies cater to the basic necessities of people. People need to buy food (or brush their teeth for that matter) irrespective of whether there's a business cycle or not. So, the earnings of these companies are less affected even by an economic downturn. Or take pharmaceuticals, an industry that has practically no relation to business cycles. Medicines are a necessity for people, and companies selling medicines are more or less insulated from the level of business activity in the economy. That's why the FMCG and the pharma stocks are known as defensives. Some depend on business cycles of other economies The export sector is also insulated from the domestic economy. Its fortunes are linked with those of the economies to which it exports. For example, the diamond industry in India, although a cyclical one, does not depend on Indian business cycles but rather on the European or American ones. India's infotech companies too are mostly dependent on US demand. So, a crash in the US could affect them badly, but they are immune to Indian business cycles. So there you are! Now you know why a company like Hindustan Lever or Glaxo will be largely immune to the ups and downs of the economy. And hence, belong to the defensive category. On the other hand, the fortunes of Reliance Industries, a global petrochemical giant by all means, are determined by the petrochemical price cycles. Which is why it is called a cyclical.
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Everything about bonus...

If you've attended any annual general meeting of any company, one issue that shareholders never fail to sally forth - other than the demand for higher dividend - is "Chairman saab, is saal kya bonus issue offing me hai?" ("Mr Chairman, is there a bonus in the offing this year?"), which sometimes also takes the sarcastic tone of "bahut deri se aap ne hum chhote shareholders ko koi bonus nahi diya?" ("it's been a while since you gave us small shareholders bonus shares?"). The big "bonus" question seems so important to most shareholders, we thought we should evaluate why they make this supernormal demand. But before we get into the relevance of a bonus issue, we'll touch upon what a bonus issue is, and why companies have been issuing bonus issues since time immemorial. What's a bonus issue? Bonus is an issue of free shares by a company to its shareholders in proportion to their existing holdings. In short, it means that the company has turned part of the profits and reserves to capital. So while the reserves stand reduced, the capital has increased. For example: You own 100 shares in a company and the current price is Rs1,000 per share. If the company announces a '1 for 1' bonus issue and issues you 100 more shares, you now own 200 shares. Does that mean your holding doubles in value? No, because the market will adjust the price of the shares so that the total value of your holding remains what it was before. In the above example, the share price would adjust to about Rs500 per share, so you still have a holding worth Rs100,000. Similarly, the dividend per share will adjust pro rata. Suppose company A, with an equity of Rs60cr and reserves of Rs120cr, announces a 1:1 bonus, there is no change in the net worth but the earnings per share changes. But hold on, the change has been to the extent of the change in the share price. So, effectively, there is no change in the share value of the shareholder.
Company (A) Equity Reserves Profit New worth Book value Price per share EPS For Share holders No of shares Value of holding -
Pre bonus 60 120 450 180 30 1,000
Ex bonus 120 60 450 180 15 500
100 100*1000 = 100,000
200 200*500 = 100,000
What good a bonus issue does Wait, there may be something positive about a bonus issue. Let's dwell into this argument further and provide reasons for the relevance of a bonus issue. The main objective of having a bonus issue is to make the shares more marketable. With more shares in circulation and a lower share price, a company expects better liquidity and higher investor interest in its shares. Let's take the example of MRF's shares, which see little activity owing to the illiquid nature of the stock (the company's equity is only Rs4.24cr). But if MRF were to issue a bonus issue the liquidity in the stock would improve. Also the company is trying to signal that it is now capable of servicing a large shareholder base. Picking the finer points So far, so good. But the important question is: is that company capable of servicing a large customer
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base? If so, can it maintain its dividend ratio? Remember, next year, the company would have to shell out a large part of its profits to the shareholders, even if it maintains it previous dividend ratio. And if it does maintain its ratio, it is possible that the company might be putting back a relatively smaller part of profit back into the business. And this in turn might have other implications on the company. Let's take the case of Century Textiles. The company issued its fifth bonus issue in 1997. The bonus of 1:1 was issued to reward its shareholders on its 100 year of operation. But the point is the company was well aware that it would not be able to service its customer base and would not be able to continue with the dividend ratio. The net result: the following year, the dividend ratio fell by 60 percent to 10% and is today giving a dividend of just 6%.
Century Textile Share capital + Reserves & Surplus Net profit Dividend
2000 193.04 785.18 6.14 6%
1999 193.04 777.16 -91.3 6%
1998 193.04 893.99 -86.7 10%
1997 46.52 1034.97 5.48 60%
Now let's look at Infosys Technologies. The company issued its third bonus since 1999 of 1:1. The good part is that the company has been able to not only maintain its dividend, but between its first bonus in 1994 and today, the dividend ratio has increased from 35% to 90% respectively. The company has been able to match its dividend as it has been growing at a compounded annual growth rate of 58%. The company has no problem in giving a bonus share issue, as it is not only able to plough back sufficient funds into the company, but also give its shareholders a good dividend.
Infosys Share capital + Reserves & Surplus Net profit Dividend
2000 33.08 800.22 293.52 90%
1999 33.07 541.36 135.26 75%
1998 16.02 156.94 60.36 60%
Bonuses are like pizzas The two examples above amply demonstrate that on its own, the bonus issue has no relevance if it isn't serviced well by the company. Even from an investor's point of view, a bonus share issue does not add up to capital appreciation. An investor may still be motivated because the investor is hopeful that his next dividend will fetch him higher returns. But like we have already seen in our earlier example, much depends on the performance of the company. Remember: a bonus issue is like a pizza. You could cut it into as many slices as you want, it still won't increase the size of the original pizza. Also, like a pizza, enjoy your bonus issue, but take it with a pinch of salt!
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If your dil maange more, check out this section for various articles on investing in stocks. Happy reading! Chapter 1: On Stocks Chapter 2 Chapter 3: The rest
Ever wondered how the budget affects the stock market? Click here Article 1: Limit Order | Jan 19 2001 You think placing an order is easy? Dream on! Article 2: Arbitrage between NSE & BSE | Jan 1 2001 A hard look at what this arbitrage business between NSE and BSE really means.
Chapter 2: On Stock Markets
Article 3: Fiscal policy and the markets | Aug 9 2002 There's no escaping fiscal deficit. Ever wondered how rising fiscal deficit affects the stock m... Article 4: Monetary policy and the stock market | Mar 2 2000 The monetary policy has everything do to with inflation, interest rates and the stock market. W... Article 5: The MSCI Index | Apr 6 2000 Discover why the Indian stock market keenly watches the changes in the MSCI Index...
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Article 6: Meet the Sensex | Sep 15 2000 We all know what the Sensex is. Or do we really? Article 7: Stock Auctions | Nov 6 2000 Stock Auctions - the necessary evil that protects stock exchanges and investors. Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page On Stock Markets More on Investing - scheme Chapter 1: On Stocks Chapter 2: On Stock Markets Chapter 3: The rest
Limit Order
Ever overheard a typical conversation between a broker and his client? Here is an excerpt of what it is usually like? Client: What is the market rate of Infosys? Broker: Quoting Rs7,500/505? Client: OK, buy 100 shares of Infosys? What will the broker do now? He will buy Infosys shares in the market at any (the best) available price till he has a 100 of them. By buying shares for his client in this manner, the broker just executed a 'Market Order'. What is a Market Order? A 'Market Order' is an order to buy or sell a stock immediately at the best available price in the market. Sometimes it is referred to as an 'Unrestricted Order', since it comes with no conditions attached from the client. Hence, it is the simplest order that can be placed in the market. The client just informs his broker to execute the trade and the broker executes the trade at the best price available in the market. Interestingly, it is the only order that guarantees execution unless of course the 'circuit breakers' set by the exchanges come into play! Hmm! Could anything go wrong here? Imagine a situation where just as our client is placing his market order, a big fund places a 'market order' to buy 20,000 shares of Infosys! The price is soaring through the skies and in the melee our client manages to buy his 100 shares of Infosys at Rs7,700! Our client is caught completely unawares. Since the client thought that he was buying just 100 shares, he would have assumed that his trade would get executed very close to the market price of Rs7,550. In the end, he bought 100 shares a good Rs150 higher than expected. What if the client was playing it tight and cannot fork out the extra Rs15,000 that his 'market order' resulted in...? Is there any way of avoiding these hazards while placing an order? Hallelujah! Thank God for small mercies like the 'Limit Order'. What is a Limit Order? An order placed with a broker to buy or sell at a predetermined amount of shares at a specified price or better than the specified price. So how would the conversation of our client with his broker have gone if our client knew about 'Limit Orders'? Client: What is the market rate of Infosys? Broker: Quoting Rs7,500/505?. Client: OK, buy 100 shares of Infosys at Rs7,550. What will the broker do this time around? He will buy 100 shares for our client at a price of Rs7,550. In case a fund places a big 'market order' to buy 20,000 shares of Infosys on the same day and in the process takes the price to Rs7,700, our broker will wait for the price to come back to Rs7,550 before buying shares for our client. Know the limits of a Limit Order A good question may crop up at this stage: What if the price does not drop below Rs7,700 at all? Well, what can we say? Our client missed an opportunity to probably make a decent profit on Infosys? ! Too bad. In other words, there is a flip side to using a 'Limit Order' vis-?is a 'Market Order'.
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Which one, when? That depends on your timeframe This depends on your time horizon. In case of our client, it depends on what he is buying the 100 shares of Infosys for. If he is buying these 100 shares with the intention of selling them within a month at Rs8,500, then it makes a lot of difference whether he buys it at Rs7,550 or Rs7,700. On the other hand, if he is buying these 100 shares with the intention of holding it for the next five years during which time he hopes to sell it at Rs15,000, then the difference of Rs150 a share he sacrifices now pales in comparison to the profit of Rs7,450-7,300 per share he hopes to make over this long period. In case the price never drops below Rs7,700, our client would have missed out on a Rs7,300 profit in 5 years because of insisting on saving Rs150! Reminds us of the proverb " Penny wise, pound foolish." Of course, the knowledgeable amongst you would have figured out that 'Limit Orders' are more useful for the traders whereas the 'Market Orders' are more useful for the investors. The tricky question is how do you set the limit for a 'limit order'? The limit can be set based on your perception of what is the right value. After all, we have our own perception of value when we buy shirts or vegetables. This goes for stocks as well! For traders, the limit price depends on the potential profits they see from that level, and their riskreward playoff. By the way, limit orders allow an investor to limit the length of time an order can be outstanding before cancelled. A quick look at the various limit orders that can be placed: End of Day: Any order to buy or sell a stock that automatically expires if not executed on the day the order is placed. Good till Date: Any order to buy or sell a stock that automatically expires if not executed on the date specified when the order is placed or the end of the particular settlement on the exchange, whichever comes first. End of Settlement or Good Till Cancelled: Any order to buy or sell a stock that automatically expires if not executed by the end of the settlement on the exchange unless the order is cancelled during that period. Now that we have understood the basics of 'Limit Order', it is time to move on. Next, we will understand the 'Stop Loss' order better.
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Arbitrage between NSE & BSE

These set of transactions are probably the most badly understood transactions. The financial dailies have added to its popularity by just displaying closing price differences between the two exchanges to highlight profit making opportunities. But they are misleading as very few shares actually change hands at that price. But to top it all these transactions are not 'arbitrage'! The fact that you use the word 'arbitrage' must mean that the transaction is riskless and hence safe! Are these transactions really riskless? The arbitrage between NSE and BSE has two parts to it. In the first stage you sell on NSE and buy on BSE at the end of settlement (Tuesdays of every week) and then reverse the transaction on the very next trading day (buy on NSE and sell on BSE). Why does arbitrage need to be executed in two phases? The first part leaves an open position on two different exchanges with not only two different settlements but also two different settlement standards. Hence, you need to get your delivery from BSE and deliver at NSE. One goof up somewhere would mean 'auction' and 'penalty'. What was meant to be a 'free' lunch can end up being a very 'costly' luncheon. However, it's true that with dematerialisation the risks of delivery have been mitigated to a large extent Once you have two parts to the transaction, you are still taking a risk- an overnite price risk. After all, prices can change sharply the following day on both the exchanges. You can say that you are betting on relative price differences between BSE/NSE and these could move in tandem after all. But what if the stock hits the lower circuit or the upper circuit? You can buy on one exchange but cannot sell on the other or vice versa. Gosh! You cannot complete your transaction and might get saddled with the position! In short, this is not 'arbitrage' as it is not riskless. Unable to coin a better term people called it so. It is a misnomer.And it probably makes sense for a broker to indulge in such so called 'arbitrage' transactions. For normal traders, it does not make sense paying brokerage four times and still carry out the transactions between the exchanges. A better option is to arbitrage between futures and the cash market or just take part in 'vyaj badla'. In case you wish to know more about any stock market terminology, drop in a mail to us at school@sharekhan.com
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Fiscal policy and the markets

No escaping the fiscal deficit There's no escaping the fiscal deficit. The thing has escaped from the pink papers, where it rightfully belongs, to the ordinary newspapers. The investor has enough on his mind tracking his portfolio, so why does he need to bother about the fiscal deficit? Think of the government as the biggest player in the financial markets. That's the reason why we lesser mortals have to bother about it. It's a bit like the Unit Trust of India. When the UTI got into trouble last year, the markets took a tumble, and then waited with bated breath for UTI to get bailed out. And the government is many many times bigger than the UTI. Sure, the government doesn't play the stockmarkets itself, except through its disinvestment programmes, but it controls the debt markets. The government's need for borrowing money to finance its expenses is nothing but another name for the fiscal deficit. No wonder it affects the entire economy. Government borrowing affects the entire economy How does it do that? Well, if government borrows too much, it "crowds out" the private sector. The stock of financial resources (money) being limited, excess government borrowing results in there being less left over for the private sector. Also, when government borrowings increase, the demand for credit increases relative to the supply for it. So the cost of credit increases. The cost of credit is nothing but the interest you pay. And when interest rates rise, that's obviously negative for companies, as higher interest costs eat into profits. Borrowing from RBI-a surefire recipe for inflation Sometimes, the government does not borrow directly from the market but instead borrows from the Reserve Bank. That's actually equivalent to printing money, and is called, in the jargon, monetising the deficit. When this happens, the amount of money supply increases and that makes price rise as well. Don't get it? Well if we all had a printing press at home in which we could print money then we could all become crorepatis. We could afford to pay any amount to buy anything we wanted to. Everything then becomes an auction and there is no limit on how high prices can go because there is no limit on how much you can afford to pay-after all, you have a printing press at home. But that is a surefire recipe for inflation. When the government borrows from the RBI very much the same happens. Sure not all of us have a printing press. But this is one hell of a big printing press. So prices are bound to rise. And then the price that you pay for money (which is nothing but interest rates) begins to rise too up. To keep deficit in check, government raises resources through higher taxes... The moral of the story is that the government should cut its coat according to its cloth. How can the government do that? One easy way is to raise resources. The simplest way to do that, as we are painfully aware, is to increase taxes. Increased taxes takes away purchasing power from people, thereby reducing demand. It also dampens the incentive for people to work harder. During the bad old socialist days, marginal tax rates went up to over 90%, leading to a flourishing black economy. These days, thankfully, finance ministers realise that too much taxation is counter-productive. But the point is, whether the government chooses to tax more or not has implications for companies and therefore for the markets. ...and that impacts stocks While corporate tax rates apply equally to all companies, changes in the rates of excise and customs duties affect different industries in different ways. That's why we have all those analyses on budget day trying to gauge the impact of the budget proposals on industries and individual companies. Obviously stocks too are impacted. Disinvestment-a resource-raising route which also affects market The other way of raising resources is through disinvestment. Divesting the government stakes in good companies brings good quality investments into the stockmarket and helps investors. Deficit can also be checked through expenditure cuts But raising resources is not the only way to keep the deficit in check. The other way is to reduce government expenditure. Is that a good thing? It depends on the state of the economy. If there is a recession going on and there is substantial excess capacity, reducing the deficit would reduce purchasing power and hurt demand. The need here would be to increase government expenditure to kickstart the economy. The quality of the deficit is of great import At other times, however, reducing government expenditure would be a good thing. It depends, however, on what kind of expenditure you prune. If the government cuts down on capital expenditure, that is the
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expenditure required for building physical and social infrastructure, then economic growth is bound to suffer. Government investment in roads, telecom, ports, etc, has knock-on effects on the rest of the economy, improving productivity and raising investment demand. That translates into orders for capital goods companies. Growth obviously translates into growth for individual companies, raising their valuations. If, on the other hand, the government reduces subsidies, rationalises prices, and trims flab in an effort to become more productive, that is to be welcomed. In other words, it's not just the fiscal deficit that is important, but the quality of that deficit. State of government finances should concern investors The government, through its fiscal policy, has the power to control the economy, interest rates and with it, the direction of the markets. Investors have reason, therefore, to be concerned about the state of the government's finances.
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Monetary policy and the stock market

Monetary policy affects all of us You would have noticed the reams of newsprint churned out when the Reserve Bank of India announces its monetary policy every six months. Like a lot of people, you would have thought that

it is merely another reason to fill the financial pages; or, more charitably, it may be important for banks but not for ordinary investors like you and me.
The fact is that RBI monetary policy has an effect on all investors. Let's take a look how. A tool to control inflation, which directly affects interest rates Monetary policy is aimed at controlling the level of inflation & interest rates in the economy. To do that, the Reserve Bank tries to lower the money supply when prices are rising. How does it do that? By lowering the amount of money available with banks. Raising reserve requirements, i.e., the amount of money which banks must keep impounded with the RBI, is one way. Another method is to sell bonds to the banks. When banks buy bonds from the RBI, money flows out from banks to the RBI, lowering the amount of money available for lending. You'll remember that just before the 1996 election finance minister Manmohan Singh tried his best to lower inflation, believing that a lower inflation rate would improve the chances of a Congress government. He got that wrong, but in the process RBI squeezed money supply. What happened next is history. Because money was scarce, interest rates started moving up to astronomical levels. Companies found that they were starved of funds, or couldn't afford the high rates. The ultimate result was that the economy slid into a recession. So by changing the money supply, the Reserve Bank can determine the level of interest rates. Higher levels of interest rates impact corporate bottomlines and discourage companies from investing. That slows down growth. Does the process work the other way? In other words, can the RBI spark an economic recovery by increasing money supply, with resultant lower interest rates? The evidence does not seem as strong. Lower interest rates can help in creating the right atmosphere for a recovery, but it is not enough to spark one by itself. Some kind of stimulus to demand must go hand in hand as well. Impact on stockmarket In the West, where both the bond as well as the equity markets are mature, an increase in interest rates leads to more money flowing into bonds. Other things remaining the same that means less money for the equity markets. You'll remember that late last year, when the Dow showed signs of weakness, Federal Reserve Chairman Alan Greenspan decided to lower the Federal funds rate and the discount rate. Lowering the rate at which banks could access Federal funds was a signal for interest rates to go down in the rest of the economy. Money flowed from the bond into the equity markets, the Dow crossed the magic 10,000 mark, and Greenspan single-handedly saved the world! In India, the bond markets are not very liquid, and only the banks are active in that market. Since banks do not invest in equities, except marginally, there is no flow of funds from the bond to the equity markets. So the impact of monetary policy on the equity markets here is indirect, rather than through the direct route. There's yet another way in which higher interest rates affect the advanced economies. Because almost everyone in the US has borrowed up to his neck, interest rates are important for consumer spending. When interest rates rise, people spend less because they can't afford to borrow at the high rates. This lowers demand and slows the economy down. However, the RBI does have a more direct way of influencing the stockmarket. That is by varying the percentage of funds which banks are allowed to invest in the stockmarket. At present, the limit is 5 per cent of the incremental deposits of banks. That means, if a bank gets Rs100 worth of new deposits, it can invest Rs5 in the stockmarket. Unfortunately, with banks not being very keen on investing in equity, their investments been far below the limit. RBI can also influence exchange rates The central bank also has the power to decide the level of the currency both by direct intervention and by targeting interest rates, which are a key factor in determining exchange rates. If it feels the rupee is too weak, it sells dollars in the market and buys rupees. If it feels the rupee should go down a bit, all it has to do is buy dollars. The rupee's exchange rate obviously has enormous implications for importers and
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exporters. What's more, even those companies which produce for the domestic market would be affected, because the price of imports would be changed. For instance, Reliance Industries would benefit if the rupee becomes stronger, as the price of competing imports would rise. Similarly, companies which export software would benefit when the rupee weakens. Well so the next time the newspapers devote reams of newsprint to the monetary policy, scan it well-it has serious implications on the stock market.
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The MSCI Index

MSCI's index changes may see India's weight dip -FE 16/5/2000 India's weight may be hit as MSCI overhauls systems - ET 16/5/2000 MSCI index to cut India weightage - BS 16/5/2000 Yesterday, all the financial newspapers highlighted a possible revision of MSCI's world index and a cut in India's weightage from the present 9% to 3%. But what is MSCI and why are people concerned over a possible revision of its indices? Who is MSCI? Morgan Stanley Capital International Inc. (MSCI) is a leading provider of global indices, benchmark related products and services to investors worldwide. MSCI indices are the most widely used benchmarks by global portfolio managers. According to a recent survey by Merrill Lynch/Gallup, over 90% of the North American and Asian international equity assets are benchmarked to the MSCI Indices. In Europe too, over 50% of the continental fund managers peg their portfolios to the MSCI Indices. Besides this, the MSCI has 1200 customers worldwide who use its indices as a benchmark. Hence any change in these indices has a significant impact on global capital markets. What does it mean to be a benchmark? How does the global fund manger decide where to invest his money and in what proportion (asset allocation as they call it)? He needs a benchmark that indicates the available investment opportunities around the globe. The benchmark is typically an Index. The most popular global indices are the MSCI indices. The MSCI Indices (there are a basket of them) consist of various stocks from individual countries. The global fund managers can then benchmark their performance in two ways. Either they can mimic the entire portfolio of stocks and hence peg the return to that of the index or they can choose some other stocks that can outperform the return of this index. Hence the portfolio manager's investment patterns are determined not just by how attractive the companies in your country are but also by the weight of your country in the MSCI index. How is the index generated? The MSCI equity indices are constructed in a consistent manner across all countries, encompassing a total of 23 developed markets and 28 emerging markets. This consistent approach to index construction ensures proper representation of the country's underlying industry distribution and market capitalization. It allows investors to accurately compare equity performance across markets, regions and sectors. In this process, MSCI tracks developments in almost 3000 companies (both listed and unlisted) around the globe. These equities account for over 99% of the world's total market capitalization. MSCI country equity indices are constructed using the following five steps:

Define the listed securities within each country. Sort the securities into industry groups and select securities until 60% of each industry's market cap. Select the securities with good liquidity and free float. Avoid cross-ownership among stocks in the index. Apply the full market capitalization weight to each stock.
This method not only ensures the inclusion of every industry into the country's index, but also that they represent 60% of the market capitalization. In other words, one can determine the performance of a particular country's market by calculating the returns of the country's MSCI index. These 51 MSCI Country Indices are used to generate regional indices such as MSCI Europe Index, MSCI Emerging Market Index. Those global managers who want to expose their fund with a certain regional risk
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can use these regional indices. The MSCI world index is constructed by combining the MSCI country indices under certain weightages. This world index is revised on a quarterly basis and therefore the country's weightage keeps shifting on the basis of expected performance of different MSCI Country Indices. Powerful enough to affect country's capital market It is very difficult for any global fund manager to track the whole world's equity market and optimize the profit of his portfolio. MSCI Indices cover almost 99% of the entire world's market capitalization; therefore almost 90% of the global managers from North America and Asia follow these indices for their investment decisions. Here's the clincher. If MSCI revises weightage of any country in the MSCI world index then most of the global managers react to it and shift their investments correspondingly. For example, if MSCI announces any dip in the India's weightage in the world index and increases say Thailand's weightage, then global managers will decrease their exposure to Indian stocks and the money will shift to Thai stocks. Hence, these revisions of country's weight in the index can cause huge sums of capital to either flow in or out of a country changing the fortunes of its capital market.
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Meet the Sensex

What is a stock index? Probably, the first thing you ask your broker when you ring him during market trading hours is: where is the market? What does he mean when he says it is up 25 points (say)? He is referring to the Sensex being up by that much. Now one assumes you already knew that anyway. But do you know what the Sensex represents exactly? The Sensex is a stock index that represents changes in values of share prices of a select group of companies over a base period. The many uses of a stock index The companies included in any stock index are generally leaders and representatives of their respective industries. Hence an index as a whole represents the wellbeing of the most important industries in an economy. And since industrial performance is a proxy for determining the state of an economy, we could say that the stock index itself also echoes the economic welfare of a country. The index also acts as a barometer for market behaviour. So if the index value goes down, it means the market is bearish (selling, therefore not optimistic of an upward trend) and if it goes up then it is bullish (buying, in the expectation of a rise based on positive news/performance). An index can be used to benchmark portfolio performances. In our write-up on MSCI indices, we saw that almost 70% of the global managers benchmark their portfolio returns against MSCI indices' returns. Now in order to benchmark a portfolio or to evaluate the economy using the stock index, we need for it to have a value. We know that, for instance, both the Sensex and the Nifty possess values that change daily. What a Sensex value represents As per the definition of an index, a Sensex value of 4600 and Nifty value of 1400 (say) represent the change in the collective value of the share prices of select companies over a base period. The BSE Sensex came into existence in the year 1979 with a start value of 100, whereas the NSE Nifty was born in year 1991 again with a start value of 100. That means the value of the companies in the Sensex has increased 42 times in 21 years, while the value of the companies in Nifty has jumped 14 times in 10 years. Criteria for choosing Sensex companies Moving to the next question that Sharekhan senses burning in your mind: On what basis is a company elected to be in a stock index? Why does the Sensex include an Infosys and not a Wipro? Here's what companies must have to play a part in any index: Market capitalisation: The company's scrip should figure in the top 100 companies listed by market capitalisation. Also market capitalisation of the scrip should be more than 0.5% of the total market capitalisation of the index i.e. the minimum weightage in the index should be 0.5%. Industry representation: Scrip selection would take into account a balanced representation of the listed companies. The index companies should be leaders in their industry group with sound management. Scrip group: The stock should preferably be from the A trading group. Trading frequency: The stock should have been traded on every trading day for the last one year. Number of trades: The stock should be among the top 150 companies listed by average number of trades per day for the last one year. Number of shares: The scrip should be among the top 150 companies listed by average number of shares traded per day for the last one year. Trading activity: The average number of shares traded per day as a percentage of the total number of outstanding shares of the scrip should be greater than 0.05 % for the last one year. Financial track record: The company should have either a consistent dividend paying record or a
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good profitability record. Wipro does qualify on some criteria, such as the market capitalisation and being industryrepresentative, but on account of its low free float, it stays out of the Sensex. In contrast, Infosys qualifies on market capitalisation as well as liquidity and hence it forms a part of the Sensex. Sensex companies are continuously monitored on the above characteristics and if in any year, a company does not satisfy all conditions, it is replaced by another company that does have all defined characteristics. The magic of 100 In 1979, BSE decided to start Sensex (BSE-30). For this, it added the market capitalisation of all the selected thirty stocks at that time and divided the sum by a unique number to make the Sensex amount to a value of 100. This unique number is known as base of the Sensex. This base is a very dynamic number and its value keeps changing with the changes in the composition of the Sensex or with the any change in the included companies' equity. Hence for all rights issue and any other change in the equity of the composite companies, the base of the index is adjusted so that the value of the index does not get destroyed. Our Sensex is based on the market capitalisation of stocks that form part of the index. The greater the market capitalisation of a company, the higher its stock's influence on the Sensex movement. So, in the current scenario, an 8% increase in Infosys' share price affects the Sensex more than an 8% increase in Grasim's share price. But market capitalisation is not the only possible influential factor. There are some more possible factors that can move the index, but before getting into that, we shall leave you to absorb the above. Happy musing!
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Stock Auctions
Of auctions and their origin The word auction, in simple terms, implies a public sale in which property or items of merchandise are sold to the highest bidder. Did you know that auctions used to take place way back during the Homeric period in Greece? It was a means of transferring the ownership of slaves from one person to the other. This same underlying concept of auction has taken a more refined form in recent times - like the auction of commodities or the belongings of famous personalities. Have you ever been to an auction house like Christie's or Sotheby's, where works of art are sold to the highest bidder in auction? Now, you are probably beginning to wonder what we are doing discussing auctions of slaves and commodities or art auction houses like Christie's and Sotheby's here, in the investment jungle! Allow us to clarify that our intention is not to discuss art auctions per se, but auctions conducted on the bourses. Auctions are not conducted only to sell merchandise or works of art in big auction houses; they are also a common feature on stock exchanges. Why conduct auctions in the stock market? Auctions are conducted on the exchanges when, for some reason, shares (physical or demat) are not delivered to the exchange on time. Exchanges conduct auctions to penalise the party for defaulting on delivering the shares on time, and thereby to protect the sanctity of settlements. It is a necessary evil - imagine the chaos if the defaulting party went scot-free and delivered shares at its own free will. This would trigger a chain reaction of defaults. If the defaulting party fails to deliver the shares on time to the exchange, the exchange in turn is unable to deliver the shares to the party who purchased them. The purchasing party in turn might have already sold those shares before receiving them from the exchange and now it would be unable to deliver those shares on time. This vicious chain could go on and on. Therefore, it becomes imperative that auctions are held so that pay-in and pay-out of shares take place on time, in accordance with the settlement cycle of the respective exchanges. Reasons for shares to go on auction Shares come under the hammer when they have been either delivered short or found to be objectionable by the exchange. Based on the reasons why shares qualify for auction, they have been categorised into two types: 1. Auction due to shortages 2. Auction due to objection Auction due to shortages As has been discussed above, an auction due to shortages takes place when the delivering party fails to deliver its share on time to the exchange, thereby triggering the vicious chain reaction of the exchange being unable to deliver the shares on time to the purchasing party and purchasing party in turn being unable to deliver shares on time if it has already sold it and so on... One of the common reasons why shares come under auction due to shortages is the confusion that arises about the delivery date of the shares, if they are going into the 'no delivery' period. Auction due to objection Physical shares go in for auctions not only if they are delivered short, but also if they are found to be objectionable and not rectified on time by the party concerned. There are many reasons why shares could come under objection. To list a few:
Transfer deed attached to the share certificate is out of date
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Details like distinctive number, folio number, certificate number, transferor names etc are not filled or filled incorrectly on the transfer form attached with the share certificate Witness stamp or signature on transfer deed is missing Signature of the transferor is missing Delivering broker's stamp is missing on the reverse of the transfer deed Stamp of the registrar of the company is missing
When a share is returned to the broker by the exchange as objection, the broker is liable to inform the client and get the objection rectified. If the party fails to rectify the objection within a stipulated time period, then the shares go for auction. The defaulting party is then penalised by having to bear the auction price. Does one always suffer a big loss in an auction? The defaulting party does suffer a loss when their shares go in for auction. Imagine the rate at which the auction would take place if the market is rising and there is a great demand for the stock. The defaulting party would be required to pay for the difference between the higher auction price and the actual sale price of the stock. Even in the case of a falling market when stocks are taking a beating, the defaulting party does not stand to gain the difference in the auction price and the actual sale price. The defaulting party instead has to forgo the entire sale proceeds it had earned. Or even worse is the case when there are no participants in an auction. In such a case, the auction price is decided by the exchange. It varies with exchanges and is called the 'close-out' price. How is the close-out price arrived at? In three simple steps. Step one: The exchange decides upon a 'fixed' price and adds 20% to it. Incidentally, the fixed price varies with exchanges. For the Bombay Stock Exchange the fixed price is the 'standard rate/ hawala rate' decided by the exchange. This standard rate is calculated on the last day of the settlement. It is the simple average of all the trades executed on that particular day. The National Stock Exchange, on the other hand, takes the closing price of the stock under auction as the fixed price. The closing price is arrived at by taking the weighted average of all the trades executed in the particular scrip in the last thirty minutes of the trading session. Step two: The resulting price is then compared with the highest price for the stock in the settlement in which the defaulting party sold the scrip. Step three: The higher of the two prices, ie the settlement price and the fixed price plus a 20% premium, is considered as the close-out price. Which means if the fixed price decided by the exchange is higher than the settlement price, the settlement price is deemed as the close-out price. Alternatively, if the settlement price is higher than the fixed price, the stock is 'closed out' at the settlement price. Understand things with Reliance Let us understand this better with an example. Let us assume that a party has defaulted on shares of Reliance Industries (RIL). And his shares are up for auction on the BSE. The BSE 'fixes' the 'hawala' price for RIL at Rs320. And as per rule, it also adds 20% to the fixed price and arrives at the final price of Rs384. Let us make another assumption at this stage. That the highest price in the settlement in which the defaulting party had sold the stock, was Rs400. Now, obviously, the close-out will take place at the settlement price of Rs400, as it is higher than the fixed price (Rs384). Other side of the coin What if the settlement had taken place at a price less than the fixed price of Rs384? What if it had taken place at, say, Rs305? Well, then the fixed price will be taken as the 'close-out' price as it is higher than the settlement price. And the stock will be auctioned at Rs384. By now you must have got a fair idea about the kind of losses and inconveniences that one is forced to face if his shares go into auction. Which is why it becomes imperative that as responsible market players we maintain the sanctity of settlements by ensuring our shares get delivered on time.
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If your dil maange more, check out this section for various articles on investing in stocks. Happy reading! Chapter 1: On Stocks Chapter 2: On Stock Markets
Chapter 3
Chapter 3: The rest

Everything else you wanted to know... Article 1: For mutual benefit | Oct 31 2002 You want to invest in a mutual fund but have doubts? Article 2: A wide choice | Nov 26 2001 There are schemes and schemes: open-ended, close-ended, debt... which MF scheme should I go for? Article 3: Interest Tax Shield | Nov 13 2000 A look at how tax makes debt more attractive. Article 4: Mortgage Backed Securities | Jan 2 2001 Making sense of a mortgage backed security. Article 5: Of bonds and debentures | Nov 29 2001 It's time we understood the subliminal differences between these two financial securities. Classic Account SpeedTrade Dial-n-Trade Portfolio Management Commodities
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page The rest More on Investing - scheme Chapter 1: On Stocks Chapter 2: On Stock Markets Chapter 3: The rest
For mutual benefit

How does a mutual fund make money? Investing in a mutual fund is easy. All you have to do is to buy shares of the fund (called units) and become a shareholder. Your money, pooled with money from other investors, is what constitutes the fund. These funds are then invested by a professional money manager in various stocks, bonds etc. So how does a mutual fund make money? In two ways: by earning dividends or interest on its investments and by selling investments that have appreciated in price. The fund pays out, or distributes, its profits (less fees and expenses) to its shareholders. That's how you make money. Most funds offer investors the option of reinvesting their distributions in the fund by buying more shares. Why invest in a mutual fund? Well, there are several reasons. First, since a fund can own hundreds of different securities, its success or failure is not going to be dependent on how well a handful of securities perform. In other words, a mutual fund is well diversified. Spreading your money in this way among many different companies and industries effectively reduces your risk-it reduces the possibility that you may lose money. This diversification is one of the biggest advantages of mutual funds. For most of us, the amount of income and investment knowledge required to accomplish similar diversification would be impossible to obtain. Also, sharing expenses with millions of like-minded investors, through a mutual fund, significantly reduces your investment cost. That's because a mutual fund is an "institutional trader" and can therefore buy securities at wholesale prices. There's also an additional reason for investing in mutual funds now. The dividend in the hands of the receiver (that means you!) is tax-free. By investing in a well-managed mutual fund, you share the expense of hiring a professional money manager with a proven track record. Your Rs500 will receive the same attention, and get the same returns, as the money of institutional investors, who place billions of rupees a year. Choosing the right fund is critical There are other benefits. You don't have to bother with the task of keeping a record of your investments. Your investment is liquid, at least for open-ended funds, and you can surrender your units to the fund and get your refund within a few days. Of course, not all funds are equally liquid, which is why choosing a fund is so important. Before you buy units in any mutual fund, it is important that you know exactly how much it is going to cost. All mutual funds charge a management fee. It doesn't matter if you buy from a bank or a broker, you will pay a management fee. These fees are usually given as a percentage of the fund's total assets and pay the administrative costs and the wages and bonuses of fund managers. In addition, some mutual funds charge a "load" when you buy or sell your mutual fund units. A fee when you buy your units is known as a frontload, and if the fee is on redemption, it is known as a back load. What is the Net Asset Value of a fund? The net asset value of a mutual fund is the rupee value of one unit of the fund and is calculated by dividing the current market value of the fund's assets, less liabilities, by the number of units already sold. For example, if the fund you are interested in has assets worth Rs20cr, after deducting liabilities, and there are 1cr units already sold, each unit is worth Rs20 (Rs20cr divided by 1cr). This means you would pay Rs20 for one unit of the fund, and the NAV is Rs20. The only way the NAV will change is due to the rise or fall in the market value of the assets held by the fund. Let's say that the same fund's assets increased to Rs30cr due to some great investment decisions of the fund manager and the number of units outstanding (sold) remained unchanged at 1cr. The net asset value of each unit you held would now be worth Rs30 (Rs30cr divided by 1cr). Anyone now buying into the fund would have to pay the new NAV of Rs30 per unit. If you decided to sell, you would have made a capital gain of Rs1,000. On the other hand, if you decided to stay with the fund, this capital gain would be paid out in the form of a distribution of the Rs1000, or be reinvested in additional units. Once distributed, or converted into additional units, the NAV will fall. Clearly, the NAV will fluctuate according to the market value of the stocks and bonds the fund has invested in.
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A wide choice
A wide choice The investment pages of any pink newspaper will give you the lists for scores of mutual funds. The variety is mind-boggling. You can take your pick from open-ended funds, close-ended funds, debt funds, money market funds, tax planning funds, balanced funds, gild funds et al. But before you put your money into any of these, there are two important things to remember. These are the fund's investment objectives, and its level of risks. You'll first have to decide what your investment objectives are, and then see which fund matches those objectives. Investment objectives Every mutual fund has a specific investment objective. A fund that seeks to provide safety of your principal amount or capital as its main objective will obviously invest very conservatively, preferring safety to risk. Income funds, on the other hand, will aim to provide investors with stable and regular payments in the form of a monthly or quarterly cheque. Funds that have growth as their objective will invest in equities to increase the value of the fund's assets and provide investors with long-term capital gains. Some funds seek to balance the objectives of income and growth in one package. Risk Simply speaking, risk is the possibility that an investment may go down in value or not perform as well as expected. Even your savings bank account is subject to erosion on account of inflation. While government securities are free of credit risk, they are exposed to market risk. We take a look here at the varieties of risk: Credit risk: This is the possibility that the company holding your money will not pay the interest or dividend due, or the principal amount when it matures. Interest-rate risk: The possibility that a debt instrument, such as a bond, will decline in value due to a rise in interest rates. Market risk: The risk that the value of your investment will decrease, as prices fluctuate in the market. The risk-reward trade-off Now for the trade-off between risk and reward. The simple rule is: The higher the risk, the bigger the potential reward. So how much risk should you be taking? It depends. If you're young or can afford to lose money, then you can take more risks. The older you get, or the less financially well off you are, the less risk you can take. Historically speaking, stocks have outperformed other financial instruments over time. Kinds of funds There are two broad categories of funds: open-ended and close-ended. Close-ended funds are those which have a fixed date for winding up. A close-ended fund for five years will, for example, return all its money to unitholders after five years. These funds collect subscriptions at one point of time, run for a fixed period, and are then redeemed. In contrast, an open-ended fund has no fixed redemption date. Instead, these funds will buy and sell units to the public continuously, at a price announced by the funds and linked to its NAV. Within these two broad categories, you can have several different types of funds. Money-market funds invest primarily in treasury bills and other very short-term instruments, such as commercial paper. Such funds usually pay a few percentage points more than savings bank deposits and have very little downside risk. UTI's MMMF, for example, has earned a return of 10.67 per cent in the last year. Fixed income or debt funds invest in some combination of treasury bills, debentures, and bonds. The aim of fixed income funds is to provide high, regular income payments with the possibility of some capital gains. Gilt funds are those funds which invest only in government securities. Safety is obviously the main objective of such funds. But while there is no question of the government defaulting on its own bonds, it is also a fact that the market prices of these bonds fluctuate. So while you may not be exposed to credit risk, market risk is very much a factor to be reckoned with.
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Growth or equity funds invest in ordinary shares of Indian companies and are recommended for investors seeking long-term growth through capital gains. An investment time frame of at least five years is generally recommended for this type of fund. Balanced funds provide a combination of income and growth by investing in a mixed portfolio of stocks, preferred stock, bonds, and money market instruments. Index funds are funds whose investments replicate a benchmark market index, including the weightage of different stocks in the portfolio, so that the performance of the fund mimics the movement in the index. Factors to consider while picking a fund First, assess the level of risk you are comfortable with and pick a fund which has the same investment objectives. Second, consider the track record of fund managers. It is important that you check the long-term track record to eliminate the possibility of a flash in the pan. Third, choose low-cost funds.
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Interest Tax Shield

In the Utopian world where there are no taxes and no risks of bankruptcy either, the value of a firm is independent of its financing decisions. While use of debt increases the overall returns to the shareholders (due to leveraging), the increase in returns come at a higher risk. So firms opt for the use of debt so long as the addition to risk is within limits. Thus the liability side of the balance sheet is not the primary determinant of returns. The money that is made is dependent on the firm's operations - that is, on the asset side. In the real world, there are taxes that need to be compulsorily paid, debt increases the overall income that is derived from the firm's operations. How? Assume that a business is funded with Rs150 of capital and it generates a profit before interest and tax (PBIT) of Rs25. Here is how the pay-off looks in a zero tax world. Assume that the interest rate is 12%. Scene 1: Zero Tax
Equity Debt PBIT Interest PBT Tax PAT Income to shareholders Income to debt holders Total
150 0 25 0 25 0 25 25 0 25
75 75 25 9 16 0 16 16 9 25
It is clear that whether the funding is through equity or debt, the total income that the firm has yielded to its shareholders and the debt-holders is the same. Now over to the real world where the tax rate - the government's share in the business - is 35%. Scene 2: Tax rate is 35%
Equity Debt PBIT Interest PBT Tax PAT Income to shareholders Income to debt holders Total
150 0 25 0 25 9 16 16 0 16
75 75 25 9 16 16 10 10 9 19
It's evident that in the real world, mode of financing does make a difference. Debt adds to the overall
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income from the business to the stakeholders. Why the difference? Interest is a tax-deductible expense. This means interest is treated as an expenditure prior to the calculation of tax. Hence the amount of tax payable is reduced due to interest. Thus interest provides a benefit or a "shield" against tax. By what amount is the tax reduced due to interest? The tax is reduced to the extent of tax rate multiplied by the interest amount. This benefit is called 'interest tax shield'. In the example we have cited, the total income to the shareholders and the debtholders in Scene 1 (100% equity financing) is Rs16. The total income in Scenario 2 (50% equity, 50% debt) is Rs19. The difference between the two, Rs3, is the interest tax shield.
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Mortgage Backed Securities

A mortgage-backed security is a debt instrument backed by a pool of mortgage loans. Investors receive payments from the interest and principal payments made on the underlying mortgages. Typically, the way this would happen is as follows... Let us say (for eg) that Housing Finance Company (HFC) has financed a number of individuals for the purchase of a house. Now, a loan is a specific agreement between the company and the borrower. It is not a tradable instrument and is it not liquid. The capital of the HFC would be blocked in this loan till such time that it receives the sum back by way of repayment over the next 10, 15 or 20 years. HFC would then pool some of these loans together and transfer them into a separate legal entity. This entity would be entitled to receive the amounts due from the borrowers over the life of the loan. At the next stage, this new entity would then issue debentures or as it would be called in this case Mortgage Backed Securities (MBS), which are secured against the receivables from the borrowers. HFC would continue to manage this special entity that holds the pool of mortgage loans. The advantage to investors in the MBS is that they have not taken a direct loan exposure to a specific borrower. MBS permits HFC to create a self-financing mechanism for financing housing loans. Such a system enables the supply of housing finance to enlarge beyond traditional limits and hence expands the housing market itself. As for the government's initiatives to expand this market, we are not fully conversant with the nittygritty of any policy initiatives that the government has taken (or not taken) or of the legal reforms that are required to enable this product to be a success. But perhaps, there are some bankers or financers or lawyers out there who work in this field and might be able to shed more light on this subject.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Before we get to differentiating a 'bond' from a 'debenture' , we need to understand one thing. That when ever we buy a bond or a debenture, we are loaning our money to an entity for a fixed period at a specified interest rate. So the entity has a predefined commitment to pay a fixed sum to us unlike a company that does not commit any specific dividend to a shareholder. What if the entity defaults on its commitment? Hence, you are taking a 'credit risk' when you buy a fixed income security like a 'bond' or a 'debenture'. In the US, credit risk distinguishes 'debentures' from 'bonds'. Debentures are unsecured debt without any collateral that rely entirely on the creditworthiness of the borrower. Bonds on the other hand is secured debt. In the Indian context it is completely different. Indian laws have muddled the distinction between 'debentures' and 'bonds' in the normally understood sense. In fact 'Debentures' is used to cover all fixed income borrowings from the private sector (non government borrowing). So bonds issued by the private sector will also be one form of debentures! Ah ha! Life is not that easy. Indian Companies are not allowed to raise funds through bonds! As there is no written agreement directly between the issuer of the bond and the bond holder to fulfill the payment obligations. 'Bonds' are normally promisory notes and hence carry higher credit risk. Hence apart from the government only Indian financial institutions can raise funds through bonds. The rest More on Investing - scheme Chapter 1: On Stocks Chapter 2: On Stock Markets Chapter 3: The rest
Of bonds and debentures
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Investing Book Reviews Chapter 1: Investing Chapter 2: Stock Markets
The Art of Speculation

by Varsha Chitale Varsha is a graduate of the London School of Economics, has over a decade's experience in finance and consulting. She was a research assistant at the Indian Institute of Management, Bangalore. She later moved to the Strategic Management Centre, Pune, to explore areas of interest with overseas consultancy organisations and to monitor the Indian Business Environment for the benefit of Indian clients and overseas companies with an interest in India. She is now one of the core members of the ValueNotes editorial and management team.
A look at the difference between speculation and investment, based on the timeless book, "The Art of Speculation" by Philip Carret Philip Carret was a bond salesman, financial journalist and mutual fund manager, but above all, an investor with extraordinary vision and ability. He is revered as the founder of the first mutual fund, The Pioneer Fund. A $1000 investment at the fund's inception would be worth $2.3 million today. Buffet refers to his record as" the best long-term investment record of anyone in America". I cringe a little every time my old aunt wants to discuss what's happening in the markets. "If people gamble", she says, "they should not get so upset if they lose money", referring to one of her card group peers who's been whining lately. I've given up trying to convince her that buying and selling shares does not necessarily constitute gambling (although I'm sure there are many who do gamble on the markets). The difference between speculation and investment is much harder to make. There is an element of speculative risk in every business and every investment. A proactive purchase manager stocks up materials whose prices he expects to shoot up and minimises inventory of those that he thinks will become cheaper. One way of distinguishing between the two is by looking at the time-span for which the investment is made. Speculation is mainly done for short-term gains; investments are made with a longer-term perspective. But hey, investors often cheat on their original intentions. Long-term investors liquidate their investment in a hurry if there is a sudden spurt in prices, and speculators sometimes end up holding their buys much longer than they had originally intended. One thing is certain though - it's not easy to be a good speculator; there are no cardinal rules, no mechanical formulas, that can get a novice there. In that sense, it is definitely an art that has to be developed painstakingly (the pain coming from losing money to learn every lesson). Philip Carret's 'The Art of Speculation' is actually about "speculative investment" rather than "the more dangerous and less useful type of speculation which borders on gambling." That's why, though the title suggests otherwise, the book reads very much like a guide on security analysis. The book was written in 1930, and that reduces the readability of the book for the simple reason that the companies and the industrial and economic scenario, which the author refers to very extensively in the book is not familiar today. If one does plods through what in parts, becomes heavy going, though, there are some timeless pearls of wisdom to be unearthed. Carret's twelve commandments for speculators, that according to him, summarise the wisdom contained in the book give an 'instant' flavour of his basic thinking and are valid even seventy years after they were first penned. The first few commandments urge conservatism in investing - not at all what one associates with speculation. The first one extols the virtues of diversification to reduce risk. Never hold less than ten securities in five different fields of business. The second one advises against speculating with money that one can't afford to lose - keep at least half the funds in income bearing securities. Carret also warns against borrowing indiscriminately for speculation. Borrowing only makes sense when risk of loss is low - when stocks are low, money rates are falling or low, and business is depressed.
file:///C|/Users/kushal/Desktop/frm%20prem/sharekhan/KnowledgeCentre-br01.htm (1 of 2) [07-08-2009 23:58:51]
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Carret stresses the need to reevaluate every buy every six months, but immediately cautions against turning the portfolio over too often, as the gains in the latter case tend to become marginal. Take losses quickly, he says, but profits reluctantly - probably one of the hardest commandments to follow, as most investors don't like to admit mistakes. They keep hanging on to the mistake in the hope a miraculously turnaround will make it a winner. A little like the die hard cricket fans who are glued to watching a losing match, hoping deep down that somehow the tail-enders will rescue the game (it does happen, but only very occasionally). Taking profits, on the other hand, makes the investor feel good, but why get out of a stock if it has turned out to be a winner and is likely to continue being a winner? Another commandment espouses that one should never put more than a quarter of the funds in securities where regular and detailed information is not available. That definitely sounds like good advise. In fact 25% is probably too much to put in such securities. Are all UTI investors listening? One imagines that successful speculation must frequently be based on having some privileged information. Carret however warns against paying heed to any "inside" information. Further, any decisions, he says, should be based on facts, not advice of others, no matter knowledgeable they are. At the height of a bull run, investors often get carried away by the mass euphoria. The wise thing however at this point is to liquidate some of the stocks (at least half, says Carret), and hold them in short term bonds. And a final tip - the author urges speculators to go in for long-term options (attached to bonds or preferred stock) of "promising companies", the key words being the ones in quotes - not that those are easy to identify! Speculation is an integral part of informed investing. In that sense, to be a successful investor, one needs to become a successful speculator. A large part of investment theory, both fundamental analysis and technical analysis is essentially to do with trying to form judgements about the future based on available facts. And that is an art not many are masters of. All in all, the book is highly recommended for all those who play in the markets, whether speculators or investors. And that fact that it was written seventy years ago is a sobering thought for those of us who feel that we have invented the art of winning on the markets.
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Graham and value investing

The market is not a precise weighing machine, but a voting machine. A review of the book, "Benjamin Graham on Value Investing", by Janet Lowe. Appreciating the contribution of Benjamin Graham to modern investment theory, Janet Lowe describes both his life and his investment theories. Graham is credited as being the person who "invented" Securities Analysis, and is known as the "Father of Security Analysis". Many investment legends like Warren Buffet and Philip Fischer have studied under Graham, and credit their success to his teachings. Janet Lowe is a business journalist and has won many awards for her writings. She has authored four other books on business and investment.
"Scams, frauds, market rigging? the stock market is a minefield! What is an ordinary investor to do?" Was this said in the 1920 or 2001? The answer to that is that it could have been either! Benjamin Graham, 'the father of security analysis' and the mastermind of 'value investing' helped evolve simple principles with the help of which investors could avoid the pitfalls in the lucrative, yet elusive world of stocks. Twice in his lifetime once on his father's death and a second time after the stock market crash of 1929, he had to start earning from scratch. He truly appreciated the need for caution and conservatism in investing. When Graham entered the investment game in 1914, Wall Street was a different place. Prior to the passing of the SEC Act (1934), insider trading was legal and companies' annual reports were small pamphlets with little information - most of the space taken up by names and addresses of the directors. Despite working in such an unregulated environment, Graham never adopted its ways. Instead, he persistently ferreted out more information about companies that he was studying and studiously ignored all rumours that reached his ears. An intensely rational man, he was driven by a need to develop a systematic way of evaluating securities. His thinking culminated in writing of 'Security Analysis' which he wrote jointly with Prof. David Dodd; it was published in 1934. Graham's book is the gospel of security analysts even today. The book "is as close as a secular vocation gets to a Bible", said journalist Thomas Eaton in 1990. His further desire to reach the man on the street led him to write 'Intelligent Investor' which, though smaller, had the same level of clarity and integrity. It became an instant hit not only with individuals, but also Wall Street professionals. Value investing was extremely simple according to Graham. "To achieve satisfactory investment results is easier than most people realise: to achieve superior results is harder than it looks", wrote Graham. "Benjamin Graham on Value Investing" by Janet Lowe traces Graham's thought process and the evolution of his theories, over his lifetime in great detail. It also gives vivid glimpses of Graham, the person, through the eyes of his family and friends. While the entire book is filled with lessons to be
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learnt by investors from Graham's life, Lowe additionally enumerates some of his pointers for individual investors. Graham literally created the framework for investment analysis. His 'Margin of safety', "the three right words" according to Buffet, are the essence of Graham's conservatism in investing. It is difficult to know the precise intrinsic value of a share - there can be an error in its estimation. Graham suggested a band of 20% above or below it to get a range of the fair value. A prudent investor should invest only if the market price falls short of the range. Graham propounded the net current asset value (NCAV) rule for deciding if the company is worth buying. If the NCAV is above the market price, the investor buys a bargain, because he pays nothing for the fixed assets. Though such companies are really hard to find, Graham's disciples have helped evolve his basic principles - to look for companies with hidden value that is not reflected in its market price. Graham urged investors to scrutinise the figures of the company in detail, as accounts can be window dressed to paint a misleading picture. Incidentally, he also wrote a (lesser known) book 'Interpretation of Financial Statements'. Graham believed in diversification. Investors, he felt should hold a quarter of their portfolio in bonds, another quarter in stocks and the balance 50% in stocks or bonds depending on stock and bond prices. Among stocks, investors should try to have at least 30 different holdings. He himself normally held about 75 stocks. When in doubt, he proposed, investors should stick to good quality companies with solid dividend history, low debt and a reasonable P/E ratio. While serious mistakes can be made in buying poor stocks, one can't go wrong with quality stocks at fair prices. Graham stressed the importance of a long record of paying dividends. It meant that the company had substance and a limited risk. Graham also preached patience. Since the market was "not a precise weighing machine, but a voting machine", the outcome was a result partly of reason and partly emotion. Despite all care, there was a possibility of poor returns in the short-term. Finally and very importantly, Graham dissuaded investors from following the crowds. It is important to think correctly and also independently. And to keep thinking of ways to ensure safety and maximise growth. Many of the best and most successful investors of the past century were Graham's students. The contribution of the master himself is often not adequately appreciated. Janet Lowe's book has remedied that and makes great reading. "There is only one Dean in our profession, if security analysis can be said to be a profession. The reason that Benjamin Graham is undisputed Dean is that before him there was no profession and after him they began to call it that", wrote Adam Smith in Supermoney.
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by Joydeep Ghosh Joydeep Ghosh is a post-graduate in Economics from the Gokhale Institute in Pune. He has spent several years as a journalist, and has worked with Business World, the Week and Indiainfo.com. His writings have also been published on CNET India, Readers Digest, the Hindustan Times and rediff.com
Insights into the stock markets based on the book, "Where Are The Customers' Yachts - A Good Hard Look at Wall Street," by Fred Schwed Junior. Fred Schwed JR's father was a short seller who went bust in the early 20s bull market. The author himself was a professional trader on Wall Street and lost a good deal of money in the 1929 crash, which forced him to get out. Then, he went ahead and penned two books - Wacky, The Small Boy and Where Are The Customers' Yachts. Both of them were national bestsellers.
The old classic on the markets, "Where Are The Customers' Yachts" was written some 70 years ago, a few years after the 1929-31 crash in the US markets. Despite its age, it remains extraordinarily relevant in today's times. The observations made by the author are funny as well as contemporary. The book provides significant insights into the functioning of the stock markets, and is a must for every investor. The book looks at the insanity that prevails in the business of investing, where a select group of people, like, brokers and fund managers armed with their technical analysis, valuations and other mumbo-jumbo influence billions and trillions worth of investment in the stock markets. He describes a broker as someone who "influences the customer with his knowledge of the future but only after he has convinced himself. The worst that should be said of him is that he wants to convince himself and that he therefore succeeds in convincing himself - generally badly." Schwed believes that a broker is really a gambler at heart like anyone else. But he bets on his prophecy (what is described as Passion for Prophecy) with someone else's money. More often than not, he is wrong but seldom do the investors have a choice. They, often throw in more good money after bad money leading to bankruptcies. Another group of people he targets are the mutual funds, more precisely, the fund managers. Funds, known as investment trusts in those days propagated the doctrine that by putting money in the units of the trust (read fund), investors are not forced to put all their eggs in one basket. The logic of this is that all the eggs will not go bad at once (the flip side is that they will also not increase in value at the same time). But fund managers tend to forget their own advice and get carried away by the hype, chasing hot sectors and tending to increase the risk for investors. Of course, there are a whole lot of investors who want to ride the hype as well. But fund managers get paid in millions for their expertise in picking the right stocks. They fail in this responsibility when they join the herd. His criticism of the financial community is aptly reflected in the title of the book. The author sees highly paid brokers and fund managers getting rich, but wonders, "Where are the Customers' Yachts?" Technical analysts also invite cynicism. Schwed describes them as writers "who do not believe that they can predict the future with any useful accuracy, nor can perceive what there is in their methods which should persuade anyone to think that they can". He has this to say of a technical analyst, "It is his claim that he can discern in this jagged line a pattern of behavior which reproduces
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itself and that certain of the peaks, valleys and wobbles tell him when it is about to do it again." And to complete the chartist's nature " If you have the bad taste to ask him how it happens that he is broke, he tells you quite ingenuously that he made all too human error of not believing his own charts. This na? thought comforts him; he doesn't mind so much losing his money but it would have been more than he could stand to lose his faith in his beloved chart system." Schwed gives special attention to a breed we are only too familiar with - short sellers. His father belonged to this group. Several times in his book he refers to short sellers like W. Pope, a fund manager who made a great deal of money by selling short in the 1929-31 crash. Historically, the criticism of short sellers comes from an old time classic: " He who sells what isn't his, Must buy it back or go to prison." Schwed's defense to this is: "He who buys what he can't pay for Is not the man to shout " Hooray" for." In other words, a bull is as bad as a bear. Interestingly, the parallel between SEBI's recent decision to investigate the bear cartel and SEC's after the US crash of 1929 are amazing, as is the widespread tendency to vilify sellers. Investors, brokers, fund managers and authorities are all very happy to see the boom/bull run. But soon the boom goes BOOM and everyone wants to investigate it. The similarities between this book, and today's situation are remarkable. The book has several other sections, which discuss forward trading and the Securities Exchange Commission. He talks about the investor psychosis as well as the brokers, fund managers and authorities. All these people have a significant role to play in the market. Some are there for the challenge of it while others, for the romance of it. Schwed clearly brings out that the most serious of businesses like investment have their own streak of romanticism. To put it in his words: " In our moments of sober thought we all realise that booms are bad things, not good. But nearly all of us have a secret hankering for another one. " Another little orgy wouldn't do us any harm" is the feeling that persists both downtown and up. This is quite human, because in the last boom we acted so silly. If we are old enough we probably acted silly in the last three. We either got in too late, or out too late, or both. But now that we are experienced, just give us one more shot at a good reliable runaway boom!" But as we all know there's nothing like a reliable boom and that makes markets so wonderful.
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An unreasonable man
Robert G. Hagstrom, JR., CFA, is a principal at Lloyd, Leith & Sawin, a firm responsible for over $100 million in assets and also the fund manager at Focus Trust, a no-load mutual fund. St. Peter met an oil prospector, moving to his heavenly reward with bad news. "You're qualified for residence", said St.Peter, "but as you can see, the compound reserved for oil men is packed. There's no way to squeeze you in." After thinking for a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless enough to St. Peter so the prospector cupped his hands yelled, "Oil discovered in hell!" Immediately the gates to the compound opened and all the oilmen marched out to head for nether regions. Impressed, St Peter invited the prospector to move in. "No", he said, I'll go along with the rest of the boys. There may be some truth to that rumour after all." The story, an analogy by Benjamin Graham, beautifully illustrates the herd-like mentality that generally seems to seize the stock markets. Warren Buffet, one of the greatest investors of the century had the courage to stand up against the lemming-like behaviour of the markets again and again, throughout his illustrious investing career spanning five decades. "You are neither right or wrong because the crowd disagrees with you. You are right because your data and reasoning are right", wrote Buffet. "The Warren Buffet Way", written by Robert G. Hagstrom is a simple and lucid account of Buffet's investments and investment philosophy. Hagstrom lists out the basic tenets guiding Buffet's investment decisions, decisions which incidentally provided way-above-average returns to his investors even when the markets were adverse. "I'm 15% Fischer, and 85%Benjamin Graham", was how Buffet described his own investment philosophy. Buffet's constant quest to find companies that were selling well below their intrinsic value, he acquired from Graham. Since intrinsic value is difficult to judge, there should be a large 'margin of safety' between the quoted price and the estimated value of the company - for the acquisition to be an 'investment' rather than speculation. While embracing the 'margin of safety' principle, Buffet diverged from Graham in not buying a stock merely because it was very cheap. From Fischer, he learned the value of 'scuttlebutt' - ferreting out info about the company and its competitors from as wide a variety of sources as possible before making his decision. Fischer's dismissal of the excessive stress laid on diversification also impressed Buffet and is reflected in his investment strategy. Hagstrom enumerates three business tenets of Buffet.
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Firstly, the target business should be simple to understand. Buffet never invested in a business he did not fully understand and this is the reason he gives for not investing in technology stocks even when the returns in that sector far outstripped the others. Secondly, the company should have a consistent operating history. Buffet did not like to touch companies that were turning around or making fundamental changes in their strategies, as such companies, according to him are more likely to make errors. Finally, it was crucial that the business should have favourable long-term prospects. In this context he preferred franchises to commodity businesses. He defined franchises as those businesses that provided a desired product or service, were not regulated and did not have any close substitutes. Buffet stressed the importance of the quality of management of the company. Management should display rationality in all decisions, but particularly the crucial ones relating to allocation of capital of the company. It is better to distribute earnings among shareholders than to reinvest them at below average returns. Buffet admired managers who reported their company's financial performance fully regardless of whether the news was good or bad. Additionally, managers, he felt should be able to resist mindless imitation of other managers. Buffet's financial tenets relate to how the financials of the target-company should be evaluated. He saw no reason to get excited about earnings per share. Since most companies retain a part of the previous year's earnings, it is more pertinent to look for a high return on equity (without accounting gimmickry or use of undue leverage). To estimate the value of the company, Buffet used 'owner earnings' which he defined as net income + depreciation + amortisation + depletion - capital expenditure -additional working capital required. He felt that mere cash flow did not give the correct picture, as they did not take into account capital expenditure. He looked for companies with high profit margins and companies that used their retained earnings well. At least one dollar of market value should be created for every dollar of retained earning - his 'One dollar premise'. Buffet's market tenets, says Hagstrom, stipulate that one should never buy shares of a business without determining its value and buy only at a price well below the ascertained value (Graham's influence). Hagstrom labels Buffet "an unreasonable man". "For when we look at the recent achievements of 'reasonable men', we see, at best, unevenness; at worst, disaster." "Buffet is idiosyncratic - it is a source of his success", declares Hagstrom. Buffet's methodology has yielded him and his investors extra-ordinary profits through all market conditions - good as well as bad. Hagstrom summarises the Warren Buffet way in four steps - 1. Turn off the stock market. 2. Don't worry about the economy 3. Buy a business, not a stock 4. Manage a portfolio of businesses. "The Warren Buffet Way" makes easy reading and is a must-read, particularly for investors who may at times have felt cheated by the stock market. Buffet's ability to earn good returns even when the market as a whole is going in the opposite direction is certainly a skill worth mastering.
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Uncovering stock market profits

Joel Greenblatt is the founder of Gotham Capital, a private investment partnership. He is also the former chairman of a Fortune 500 company with over a $1billion in annual sales. He has been "beating the pants off the market". A dollar invested in Gotham at its inception achieved returns of $52 by 1997. Ordinary investors have some advantages over professional investors; they should exploit them.. Not all players in the stock market can be winners. Ordinary gals (and guys) like us compete with professional, high profile, highly qualified and highly paid experts from financial institutions to get to good investment opportunities. And even the experts are unable to consistently beat the market. Do we have any chance at all? That we may have certain advantages over the heavy weights in the arena is a wonderful thought. It is also the theme in Joel Greenblatt's book "You can be a Stock Market Genius (Even if you're not too smart)". Greenblatt illustrates various kinds of opportunities that the big players and the markets ignore for a variety of reasons, but which individual investors can in fact exploit. There are several reasons why large institutional investors neglect some of the investment opportunities in the market. Firstly, investment managers' performances are judged on the basis of how well their portfolio performs vis-?is the stock market index. And the time horizon for judging performance is relatively small (between a few months to maximum - a year). Investment managers therefore tend to skip those opportunities where the pay-off is likely to come only after a long time. Secondly, since the corpus that they typically manage is very large, they already have a large number of companies in the portfolio. Remember that there is a limit on the proportionate holding of an institutional investor in any one company. Their interest therefore remains limited to the large-cap companies. If they were to start investing in small companies, the number of companies in their portfolio would become unmanageably high. Greenblatt's secret to success in the stock market lies in identifying situations (mainly involving corporate changes) which are not of interest to the big players, but which offer a high upside potential. In this context, spin-offs are Greenblatt's favourite. When a company hives off a part of its business into a separate company, it may do so for several reasons. Greenblatt quotes a study that found that a very large number of such spin-offs outperformed their industry peers by a whopping 10% per year in the first three years after the spin-off. The parents of the spin-offs also outperformed their industry peers by 6% during the same three-year period. Institutional investors are often uninterested in spin-offs, as the companies tend to be small in size. The shares of the spin-off are generally not sold, but distributed among the parent company's shareholders. The shareholders typically sell them off without regard to price or fundamental value as their primary interest is in the parent company. The initial price after the spin-off, therefore, tends to be depressed - a great bargain. Greenblatt strongly emphasises that in every corporate change it is important to determine where the interests of the insiders (directors of the company) lie. If they have a large stake in the spin-off, it
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means that there is a high level of commitment to making the spin-off a success. The credentials of the parent company are also very important in evaluating spin-offs. Another opportunity is in mergers. While Greenblatt warns against risk arbitrages, i.e., buying stock of a company that is subject to an announced merger or take-over, he is very much in favour of merged securities. Risk arbitrages are subject to too many uncertainties (the merger may not even go through), so the chances of burning one's fingers are high. However, in mergers, the acquirer sometimes pays for the acquisition in terms of securities other than stock - bonds, preferred stock, warrants or rights. Institutions typically shun these securities, and individuals who receive them often dispose them in the market immediately. The price is thus driven down, making them attractive investments. Another unconventional opportunity that Greenblatt suggests is not the stock, but bonds, bank debt and trade claims of companies that are emerging from bankruptcies. Here bargains are created as there are a large number of anxious sellers and the businesses tend to be unpopular. However, one needs to be very careful in choosing the 'right' bankrupt companies to invest in. Major restructuring by companies could also be a place to seek out investment opportunities. One can either invest after restructuring has already been announced or when a company is ripe for restructuring. Funnily enough, many equity analysts tend to drop coverage of companies that are undergoing major corporate changes. Of course, like Buffet, Greenblatt too shuns complex restructuring where one cannot understand what is really going on. Greenblatt sees recapitalisation (buyback) transaction as an investment opportunity. The prime reason that makes buyback companies interesting is that buyback of shares increases the leverage in the balance sheet of the company, thus increases the tax saving which can then be passed on to the shareholder. According to Greenblatt "there is almost no other area of stock market where research and careful analysis can be rewarded as quickly and generously". "Uncover the secret hiding places of stock market profits," says the cover of the book, and Greenblatt certainly goes on to show us some unusual and unconventional places in which to look. However let the title of the book not fool us into believing that it's easy to find stock market bargains. Even Greenblatt acknowledges that a lot of reading, learning and research is involved in finding these hiding places. After all, we all know that there is no free lunch!
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Short sellers must be the most reviled characters among stock market participants. For most of us, it is only natural that you first buy the shares of a company and then sell it at a later date, hopefully at a higher price, in order to make a profit. It seems almost unethical that someone would try to profit by first selling shares (which they do not own in the first place) and then buy them back at a lower price in order to make a profit. You will believe us all the more if you remember the ruckus about the bear cartel that broke out after the budget. The bear action upset our finance minister so much that it led to a ban on short sales, which has just been lifted. For all of you who believe that short selling is next only to worshipping the devil, I recommend that you read "SOLD SHORT: Uncovering deception in the markets," by Manuel P Asensio. Mr Asensio, a Cuban ?gr?nd a graduate of Harvard Business School made his first killing in the stock market (on the short side :-)) while still at Harvard. Dupont was in the process of acquiring control of a company called Conoco through a two-step process. The first step involved a straight up cash offer and the second was a swap for Dupont shares which were then valued at $67 a share. Seagrams had been a contender in the battle to take over Conoco. Even though Dupont had already taken control of Conoco through its cash offer, Seagrams did not withdraw its offer of $110 per share for a limited number of Conoco shares. As a result of this strange situation, the Conoco stock traded at over US$90 per share, despite Dupont already having taken control of the company. The remaining shareholders of Conoco were stuck with a deal in which they would receive US$67 by way of Dupont shares. Mr Asensio took the bet and rightly so that once Seagrams' cash offer closed the market would price Concoco shares sharply lower than US$90 and closer to the US$67-as valued by Dupont. He chanced upon some short term $90 Conoco puts that were trading at $1 and invested his entire savings in them. If the stock dropped to US$67 once the Seagrams offer closed then Mr Asensio would stand to make $23--a 2300% gain. Of course, the risk was that the puts might expire worthless, as the stock might take longer to wake up to the facts. But Mr Asensio went ahead and took the risk and the rest as they say is history. Investing Book Reviews Chapter 1: Investing Chapter 2: Stock Markets
ignore
An interesting tale
His career graph
He set up his own brokerage in Florida and then went through some fairly indifferent years, which included a short stint working at a major US Investment Bank--Bear Sterns. In 1993, he set up shop again as Asensio & company and that is the firm he has run since then. It is not that he conceived this as being a house specialising in short selling. In 1994 and 1995, they did research mostly on the long side but as Mr Asensio puts it, "We got into short selling because we were fundamental analysts coping with a raging bull market". It is better that I allow Mr Asensio to explain in his own words his rationale for what he does: "Sometimes overvaluation occurs naturally, despite complete and accurate disclosures about a company's risk and prospects. But sometimes overvaluation occurs because investors are buying based on false statements and/or the omissions of material negative facts. I call these misrepresented companies grossly overvalued."
It is these grossly overvalued companies that Mr Asensio goes after. In that sense he is not after a company only because it has a rich valuation, which is unfortunately how many of us understand short selling. He goes after companies that do not deserve the valuation (the market capitalisation) they are getting--companies that enjoy a certain valuation only because they are either misleading investors or omitting to communicate the risks to their shareholders.
Grossly overvalued companies are his targets
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To that end, you will find that his means are almost vigilante like. He publicly confronts not just the company but also attempts to communicate and debate his point of view about the company with the shareholders of the company or with its partners and customers (if they have been misrepresented to). He documents several instances in which he threw down the gauntlet at institutional shareholders of companies he found to be fraudulent. Unfortunately, in most cases the institutional owners did no have the time to listen to him. Mr Asensio played a key role in uncovering two scandals in the fund management industry. These were cases in which the fund managers concerned were involved hand in glove with promoting a particular company's stock in violation of all regulations and ethics. Keen stock market participants will remember the Peter Young scandal at Morgan Grenfell, which eventually led to the demise of the company and the Michael Schonberg scandal at Dreyfus fund management. In the case of Morgan Grenfell, the company eventually owned up to poor supervision of its fund manger and compensated its investors. Dreyfus never publicly acknowledged the wrongdoing but it gradually sacked all the people concerned in the incident. Wouldn't we like an Asensio in our markets? The most gripping part of Mr Asensio's book is where he documents his many battles with the companies he targeted as short selling candidates. Remember, Mr Asensio was always treated as being a biased party since he publicly disclosed that his firm was basically a proprietary trading firm, which traded on its own recommendations. For those of us who saw the hype machine at full blast in the bull market of 1999-2000, the striking similarity between the tales of many of the companies he researched and our own market is telling. Many of us committed the mistake of buying stocks, which were pumped up on steroids by promoters, speculators, analysts and fund mangers. It has been a cold long winter since then as we have seen these stocks turn worthless. After reading this book, I am sure most of you will conclude that having committed short sellers--like Mr Asensio--in the market would do us more good than harm.
Need for short sellers
Copyright ? 2000 Sharekhan.com & SSKI Investor Services Pvt. Ltd. All Rights Reserved. The views contained in this column are that of the author. Sharekhan.com may or may not concur with the views expressed by the author. We do not represent that it is accurate or complete and it should not be relied upon as such.
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Welcome to the Sharekhan.com Knowledge Centre Section! Home -> Knowledge Centre Knowledge Center Knowledge Center Home School Stock Trivia Opinion Polls Book Reviews Guest Columns Page Tools Save This Page Email This Page Print This page Short sellers must be the most reviled characters among stock market participants. For most of us, it is only natural that you first buy the shares of a company and then sell it at a later date, hopefully at a higher price, in order to make a profit. It seems almost unethical that someone would try to profit by first selling shares (which they do not own in the first place) and then buy them back at a lower price in order to make a profit. You will believe us all the more if you remember the ruckus about the bear cartel that broke out after the budget. The bear action upset our finance minister so much that it led to a ban on short sales, which has just been lifted. For all of you who believe that short selling is next only to worshipping the devil, I recommend that you read "SOLD SHORT: Uncovering deception in the markets," by Manuel P Asensio. Mr Asensio, a Cuban ?gr?nd a graduate of Harvard Business School made his first killing in the stock market (on the short side :-)) while still at Harvard. Dupont was in the process of acquiring control of a company called Conoco through a two-step process. The first step involved a straight up cash offer and the second was a swap for Dupont shares which were then valued at $67 a share. Seagrams had been a contender in the battle to take over Conoco. Even though Dupont had already taken control of Conoco through its cash offer, Seagrams did not withdraw its offer of $110 per share for a limited number of Conoco shares. As a result of this strange situation, the Conoco stock traded at over US$90 per share, despite Dupont already having taken control of the company. The remaining shareholders of Conoco were stuck with a deal in which they would receive US$67 by way of Dupont shares. Mr Asensio took the bet and rightly so that once Seagrams' cash offer closed the market would price Concoco shares sharply lower than US$90 and closer to the US$67-as valued by Dupont. He chanced upon some short term $90 Conoco puts that were trading at $1 and invested his entire savings in them. If the stock dropped to US$67 once the Seagrams offer closed then Mr Asensio would stand to make $23--a 2300% gain. Of course, the risk was that the puts might expire worthless, as the stock might take longer to wake up to the facts. But Mr Asensio went ahead and took the risk and the rest as they say is history. Investing Book Reviews Chapter 1: Investing Chapter 2: Stock Markets
Sold Short
An interesting tale
His career graph
He set up his own brokerage in Florida and then went through some fairly indifferent years, which included a short stint working at a major US Investment Bank--Bear Sterns. In 1993, he set up shop again as Asensio & company and that is the firm he has run since then. It is not that he conceived this as being a house specialising in short selling. In 1994 and 1995, they did research mostly on the long side but as Mr Asensio puts it, "We got into short selling because we were fundamental analysts coping with a raging bull market". It is better that I allow Mr Asensio to explain in his own words his rationale for what he does: "Sometimes overvaluation occurs naturally, despite complete and accurate disclosures about a company's risk and prospects. But sometimes overvaluation occurs because investors are buying based on false statements and/or the omissions of material negative facts. I call these misrepresented companies grossly overvalued."
It is these grossly overvalued companies that Mr Asensio goes after. In that sense he is not after a company only because it has a rich valuation, which is unfortunately how many of us understand short selling. He goes after companies that do not deserve the valuation (the market capitalisation) they are getting--companies that enjoy a certain valuation only because they are either misleading investors or omitting to communicate the risks to their shareholders.
Grossly overvalued companies are his targets
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To that end, you will find that his means are almost vigilante like. He publicly confronts not just the company but also attempts to communicate and debate his point of view about the company with the shareholders of the company or with its partners and customers (if they have been misrepresented to). He documents several instances in which he threw down the gauntlet at institutional shareholders of companies he found to be fraudulent. Unfortunately, in most cases the institutional owners did no have the time to listen to him. Mr Asensio played a key role in uncovering two scandals in the fund management industry. These were cases in which the fund managers concerned were involved hand in glove with promoting a particular company's stock in violation of all regulations and ethics. Keen stock market participants will remember the Peter Young scandal at Morgan Grenfell, which eventually led to the demise of the company and the Michael Schonberg scandal at Dreyfus fund management. In the case of Morgan Grenfell, the company eventually owned up to poor supervision of its fund manger and compensated its investors. Dreyfus never publicly acknowledged the wrongdoing but it gradually sacked all the people concerned in the incident. Wouldn't we like an Asensio in our markets? The most gripping part of Mr Asensio's book is where he documents his many battles with the companies he targeted as short selling candidates. Remember, Mr Asensio was always treated as being a biased party since he publicly disclosed that his firm was basically a proprietary trading firm, which traded on its own recommendations. For those of us who saw the hype machine at full blast in the bull market of 1999-2000, the striking similarity between the tales of many of the companies he researched and our own market is telling. Many of us committed the mistake of buying stocks, which were pumped up on steroids by promoters, speculators, analysts and fund mangers. It has been a cold long winter since then as we have seen these stocks turn worthless. After reading this book, I am sure most of you will conclude that having committed short sellers--like Mr Asensio--in the market would do us more good than harm.
Need for short sellers
Copyright ? 2000 Sharekhan.com & SSKI Investor Services Pvt. Ltd. All Rights Reserved. The views contained in this column are that of the author. Sharekhan.com may or may not concur with the views expressed by the author. We do not represent that it is accurate or complete and it should not be relied upon as such.
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"A Random Walk..."

"Although men flatter themselves with their great actions, they are not so often the result of great design as of chance." There is no sure way to investment success. In his classic book, "A Random Walk Down Wall Street", Burton Malkiel has outlined ways to turn the odds in the investors' favour. Burton G. Malkiel is a permanent faculty at the Princeton University from where he took a doctorate in 1964, after having worked as a securities analyst for one of Wall Street's leading firms. He has also been a trustee and advisor to large retirement funds.
"How could I have been so mistaken as to have trusted the experts" commented John F. Kennedy after the Bay of Pigs fiasco. From time to time, investors have echoed similar sentiments with reference to investment analysts. The eternal search for the perfect system or theory for the stock markets has yet to bear fruit. Most of the so-called experts in investment analysis have not really reaped above normal gains from their own prescriptions. The 'random walk' proponents question the very premise that it is possible to systematically pick winners in the market. Markets, they believe, behave randomly - like the tossing of a coin. The next toss could yield a head or a tail with equal probability and the outcome has no relation to the previous outcome. The price of a share could move up or down with equal probability in a given period with no correlation whatsoever with the direction in which it moved in the previous period. Further, if all the information available about a particular stock is already reflected in the price of a stock, the stock can never be mis-priced; the question of buying an undervalued stock in the hope of benefiting from future capital appreciation does not arise! Needless to say, not too many investors subscribe to these extreme views, for if they did, the profession of 'security analysts' would be defunct. Yet, we have technical analysts, who forecast movements in share prices on the basis of charts of price history of share prices, and fundamental analysts who try to determine the intrinsic value of a share in the hope of identifying undervalued shares. Burton G Malkiel's book "A Random Walk Down Wall Street" described as the 'Dr. Spock of investment' by Paul Samuelson, is a guide for individual investors in the oft-confusing world of investing. Malkiel looks at two approaches to stock valuation - the 'castles in the air' and 'firm foundation' theories. He gives colourful examples from the past, of how prices are driven by fads, market frenzy and psychology, to describe how investors build castles in the air, which are not based on any rationality. Investors buy shares, not because the prices reflect their true worth, but because they believe they can sell them at a higher price.
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The firm foundations theory argues that prices of shares are based on their intrinsic values, which can be estimated. Prices sometimes fall below or rise above the intrinsic value, creating buying and selling opportunities. Malkiel dismisses technical analysis as a tool for forecasting future prices. If there were a system based charts of prices and volumes that worked consistently, it would be increasingly used, and that itself would undermine its efficacy. Every technique would therefore necessarily be self-defeating, according to him. Besides, extensive testing of various techniques used by technical analysts, according to him, have given results that do not favour the technician. The track record of fundamental analysts is not any better, according to Malkiel. The performance of mutual funds, which supposedly employ the best security analysts to manage portfolios, adequately illustrates this point. "No scientific evidence has yet been assembled to indicate that investment performance of professionally managed portfolios as a group has been any better than that of randomly selected portfolios', writes Malkiel. And that is precisely what the random walk theory states! Malkiel therefore believes that investors should definitely reconsider their faith in the 'super-analyst'. At the same time, he is unwilling to subscribe wholly to the random walk hypothesis. For one, it rests on fragile assumptions, a significant one being that there is perfect pricing in the markets. There is ample historical evidence to believe that the market is often 'swept up in waves of frenzy'. Secondly, information does not travel instantaneously as random-walkers would have us believe. And finally there is the question of converting the known information about a stock into a value for it. There is considerable scope for individuals to exercise their judgement and intellect in this exercise. Good stories often do go unrecognised for a while. Malkiel goes on to formulate simple guidelines for individual investors. Before entering the treacherous alleys of the stock market, he prescribes that investors should ensure that they have adequate funds in safe and liquid avenues. Medical and life insurance, for example should be taken care of first and investors should try to get the best deals on these. Secondly investors should evaluate their risk taking ability and set reasonable investment goals. For choosing stocks, Malkiel lists four general rules that he has used successfully. Investors should only look at companies that appear to sustain above average earnings for at least five years. Such companies offer potential for double benefit - a growth in earnings and also a growth in the price earnings multiple that comes from having a record of consistent growth. Secondly, Malkiel advises against paying for a stock, a price more than what can be justified on the basis of 'firm foundation of value'. That's easier said than done, though, as the intrinsic value is not so easy to determine. What is does mean is that investors should not fall prey to market frenzies. Malkiel however stresses the importance of the psychological element in the market. So, while investors should buy at reasonable prices it helps if the stock is the kind that will catch the fancy of the market. Finally he prescribes the maxim, 'Ride the winners and sell the losers". Investors in general should trade as little as possible. 'Frequent switching accomplishes nothing but increasing your tax burden if you have realised gains, and subsidising your broker'. Malkiel humbly admits that ultimately investing is an art and requires, besides talent, the 'presence of a mysterious force called luck'. "Although men flatter themselves with their great actions", Malkiel quotes la Rochefoucauld, "they are not so often the result of great design as of chance". And yet, Malkiel believes that investing is 'too much fun to give up'! 'A Random Walk down Wall Street' does not give the reader an instant formula for success in stock markets. Indeed no book can seriously claim to do so. Burton Malkiel's book does however ensure that investors do not harbour illusions about what they can hope to get out of their investment advisors and the markets. The book has lots of witty anecdotes and oodles of common sense, which makes it a must-read.
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KnowledgeCentre

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Learning To Invest In Equity

Chapter 5: Capital Structure

Chapter 2: Understanding Equities

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Are you ready for equities?

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Equity means ownership

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Dividend: the unsung hero

Dividends did make a significant difference

We are here to recognise an unsung hero--Dividend!

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CMP of HLL 58 59 63 81 138 166 225 210 -

DPS 2.27 3.48 4.40 10.24 13.92 19.86 29.01 35 -

Tot #Sh 17 18 19 20 21 23 25 28 CAGR

With Div 5,948 29.01%

W/O Div? 3570 19.94%

To add a twist to the tale enter our unsung hero?

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Equity, thy name is enigma

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Learning To Invest - In Equity

Chapter 3: Equity Risks

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Khel risky hai

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Taming the risk