A Simple guide to investing

Setting your objectives

Drawing a financial plan for your self, is the starting point for achieving financial independence. It begins
with determining where you currently are, the resources at your disposal and immediate requirements.
Figuring out your long-term goals comes next. For which, you have to keep in mind your ability to take risk
with various financial instruments, your lifestyle, your occupational profile and the number of dependents in
your family. The idea behind a financial plan is to it help the investor to specify realistic goals and improve
the possibility of meeting them within the planned time frame. However, since the goal of each individual
and family is unique, this section only makes broad recommendations that should apply to everyone before
embarking upon an investment programme.

Estimate immediate term needs

Many investors jump into the stock market without assessing their requirement for resources in the short
term. As a result, they either sell stocks much ahead of their potential for capital appreciation or book
losses on the slightest panic. Remember that the length of time you hold on to your investment is critical to
the actual risk you assume from any investment decision.

Create an emergency fund

When emergencies happen, they often coincide with great investment opportunities. Therefore, it is
important to have a cash reserve to help meet unforeseen occasions like let's say, job layoff or a medical
emergency instead of dipping into your retirement funds. A cash reserve (money market funds, which can
be easily converted into cash should do) of at least six months worth of living expenses or a medical or
disability insurance is a must.

Repay your debt

Reducing your debt is another way of increasing your net worth. Generally, you also can't get a better
return on your money than paying off your credit card debt. However, before you repay any debt, compare
what return money invested in a low-risk instrument could earn. If the return on investment is greater than
the amount of interest you are paying on the debt, invest. But if the risk-adjusted return is still less than the
amount of interest that you are paying on your loan, you are obviously better off without the loan than
investing the money.

Set a time frame for your priorities

Classify your own priorities and that of your family members into time frames, preferably periods in years to
result in better asset allocation. For instance, paying a lump sum donation for admitting your child is more
of an immediate concern (though smaller in amount) than saving for his or her higher education (which
also faces a higher inflation risk). The former may happen over the next few months or a couple of years.
But higher education will take between 15 to 18 years hence. While short-to-medium term bonds can
suffice for the former, a larger proportion of assets may be invested in stocks to combat inflation
while saving for a longer term.

How much risk can you take?

Since higher risk is the price that one pays for more generous returns, how you feel about risking your
money will greatly influence your investment decision. A totally risk averse person is typically very
conservative who does not want to lose a penny regardless of how little his or her money earns. While the
risk loving or the very aggressive investor is willing to risk most of his or her money for the possibility that it
will reward him or her tremendously.

Risk tolerance can also be measured in terms of volatility. In the sense that how much volatility in the value
of a portfolio can an individual be comfortable with? Or what are the probable emotional reactions of the
investor to an adverse outcome?

Apart from an individual's psychological makeup, various other factors also play a crucial role in
determining one's comfort level with risk. Evaluate yourself against the following parameters:
Current income or net worth

If more of your current and future wants can be met by income from non-portfolio sources, as an investor
you will have more liberty to accept risk in your portfolio. Likewise, the higher your current net worth, the
more choices or flexibility you have while making future investments decision. In such cases, a portfolio
may be geared to achieve capital appreciation through greater risk. When current income is insufficient,
investors would want the portfolio to concentrate more on generating income and preserve capital rather
than generate capital gains alone.

Age group

It is the most influencing factor in determining one's comfort with risk given a current income level or size of
net worth. To put in one sentence, an investor's risk tolerance is expected to increase with income
and wealth, but after a point, diminish with age. Check the life cycle investment approach, which uses
age as a starting point for determining risk tolerance.

Time horizon

If you're an investor with a longer time frame, you can do with less liquidity and higher risk
tolerance for greater capital appreciation in your portfolio. Less risky investments are also advised for
investors with a shorter time horizon since losses are difficult to recover in a short period of time. For
instance, a 30-year old investor has more time on his or her side to bear initial portfolio losses than an
investor who is 58-years old and nearing retirement. Hence, as time horizon shrinks more importance is
attached to current income outlook than capital gains.

Occupation profile

Your ability to take risk also depends on your occupation profile. An investor with a high level of high job
security can afford to be more liberal with risk, than someone who is not secure about his or her job.
Professionals like doctors, lawyers are found to be cautious yet at the same time also willing to assume
greater risk. Likewise investors with an entrepreneurial mindset are known to take large focused bets with
their portfolio than simply diversifying to cut risk.

Your age and your investment plan --A lifecycle guide to investing

Age often determines your investment profile. Hence, evaluate your own profile and construct a portfolio
that broadly conforms to this. You can then establish, with a certain degree of confidence, the exposures to
be taken in different investment avenues. For example, if I am five years away from retirement and have
no savings worth writing home about, then obviously my focus will be on building a portfolio comprising
largely of fixed income instruments.

We have constructed a profile which corresponds to different age profiles based on based on certain
common sense understanding of age, requirements, investor psyche. Based on this, we have suggested a
broad break-up of investments in this profile. As in most guides, this is only an indicative tool and you can
vary these figures if you desire to.

While reading through this profile, remember that the profiles matching the age bracket are not absolute in
nature. They depict typical attributes. If you perceive your attributes differently, change your risk profile
accordingly. Thus, if you are 50, single, no kids, no dependents and with a separate fund protecting your
entire post-retirement needs, park your self in the 22-30 years' profile. Similarly, if you are 26, married with
two kids, seeking to buy a house and have quite a few dependents, then you may upgrade yourself to the
next age bracket.

The funds available are assuming that tax liabilities have been provided for. Broadly, you can classify
investments in to cash and bullion, fixed income instruments and equities and mutual funds. Cash and
bullion are taken as one, as both are equally liquid and widely used as a means of savings. Savings would
also include funds in your bank savings accounts.

Apart from pure equities and fixed income instruments, mutual funds are also popular investment vehicles.
We have classified them separately since risk is relatively lower while investing in mutual funds. Moreover,
balanced funds juggle between debt and equity making an all-inclusive classification difficult.
Age: 22-30 years Profile:

You are single or are married with no kids. Dependents are not an issue at this stage and your focus is on
creating a sizeable corpus of investments for the future. Incomes typically grow at a fast rate at this age.
The ability to take risk is high and losses in the short term are acceptable. Can invest in equities with a
time frame of about 5-6 years which protects them from short-term fluctuations.

Category %
Cash and bullion 10
Fixed income instruments 40
Equity shares 30
Mutual funds-equity growth 20

Age: 45-60 years Profile:

This is the age when retirement blues set in. Children's college and higher education make demands on
your funds. This is the time when you must plan for your retirement, if you have not done it already. Hence,
risk taking ability as a whole diminishes considerably.

Category %
Cash and bullion 10
Fixed income instruments 50
Equity shares 20
Mutual funds-equity growth 20

Age: Beyond 60

You are taking life easy, some introspection, spending time with the family and maybe doing some part
time work. Or like some workhorses, you are still engaged as a full time consultant with your ex-employer.
The ability to take shocks is extremely limited and you should lower your exposure to equities. Your prime
criterion should be to have a higher proportion of fixed income investments and stay liquid to meet any
medical emergencies.

Category %
Cash and bullion 10
Fixed income instruments 70
Equity shares 10
Mutual funds-equity growth 10

Choosing between various assets

The importance of a financial plan is to ultimately lead you to an investment decision. But no investment
decision is complete without a judicious allocation of assets.

It is important that individual investors also pay attention on the allocation of their investments between
stock and bonds funds. Rather than only worry about which specific stock to invest in.

Allocating assets among various asset classes also achieves the objective of diversification. Since there
are varying levels of risks attached to different classes of assets.

Stocks are inherently known to be riskier than bonds. Bonds though less risky, return much lower than
equities over a longer term. So what's the right choice of assets for you?

In the investment classic, The Intelligent Investor, Benjamin Graham advises investors to maintain as
nearly as practicable as equal division between bond and stock holdings. When changes in the market
level raise the common-stock component to, say, 55 per cent, the balance would be restored by a sale of
one-eleventh of the stock portfolio and transfer the proceeds to bonds. Conversely, a fall in the common-
stock proportion to 45 per cent would call for the use of one-eleventh of the bond fund to buy additional
equities.
Though this may sound oversimplified, a 50-50 version should make good sense for the defensive
investor. It also gets the follower a feeling of at least responding to changes in market (and automatically
re-balancing his or her portfolio).

More active or aggressive investors can modify this plan to suit their requirements.

Otherwise, follow a rule thumb. The bond portion of your total investment portfolio should be roughly equal
to your age. The balance should be invested in shares.

So if you are 30 years old, 70 per cent of your funds should be in stocks. And at age 50, your portfolio will
be equally split between the both. And at 70, you will have only 30 per cent in stocks, which should help
your portfolio to at least pace with inflation.

Start early.

Investing is actually not as difficult as it might seem. But you will still need to give yourself enough time
before you discover how simple it can turn out to be. That's why, start early. The younger you are, the more
time you also have to learn from your mistakes, since investing is inherently risky. Also as you grow older,
you also realize the need to take limited risks with equity stocks and save more through fixed income
securities. Also for every year you put off investing towards retirement, you will need to invest increasing
amounts for achieving similar results by a specific date. For instance, at a 12 per cent compounded annual
rate of return, you would need to invest roughly twice the amount if you start six years hence than the
amount you would have to invest if you were to start today.

Know yourself.

Invest in shares or mutual funds that suit your requirements. Don't simply buy into something because your
neighbour is doing so or your broker is telling you to do so. Carefully choose securities that fit your type of
investor profile. As an investor, it important to be able to relate the risk perceived in a given security not
only to return, but also to your attitude towards risk. So it is important that you understand yourself as an
investor and your emotions towards money and comfort levels with risk. For instance, what would be your
reaction if your stock investments plumment by 35 per cent in a month? How would that affect your
medium term or long term plans?

The risk/return trade-off.

It pays to take reasonable risks in the search of higher long-term rates of returns. Equity shares promise a
higher rate of return over a long term, but the length of period also adds an element of uncertainty in
realizing that return. On the other hand, bond funds are more stable but returns are much lower. As an
investor, you should be able to judge whether the perceived risk is worth taking in order to get the
expected return and whether a higher return is possible for the same level of risk (or a lower risk is
possible for the same level of return). Smart investing will involve choices, compromises and trade-offs.
And it is you who will have to decide what combination of these factors suits you best.

Don't overpay for growth.

While investing in equities, look out for shares capable of delivering sustainable earnings growth. But it is
equally important that you don't overpay for growth. Even the best growth stock may not deliver your
dream returns if your purchase price was too high to begin with. Like Warren Buffet, one of the most
successful investors in the world today, said back in 1983: "For the investor, a too high purchase price for
the stock of an excellent company can undo the effects of a subsequent decade of favourable business
developments." So growth riding on the back of a reasonable acquisition price may be a good motto to
stick with.

The reinvestment risk.

If it suits your plan, choose a fund that reinvests your dividends or interest. That won't leave you exposed
to the risk of reinvesting the amount at equivalent or higher returns for the same level of risk. Such
alternatives are more than often not easily available. The reinvestment risk is implicitly defined for a debt
instrument. Yield-to-maturity, which is the actual yield on a bond if held to maturity, may be a familiar term
to those who invest in fixed income. But few know that this YTM assumes that each interest cheque
received by the investor is reinvested at the coupon rate. In reality, however, most investors are probably
spending this interest on fullfiling current needs. So even if investors are getting a coupon of 18 per cent on
a semi-annual debt instrument, their YTM is much lower.

Beware of the law of averages

The average, or mean, acts like a powerful magnet that pulls stock prices down sharply, often causing
returns to deterioriate after they exceed historical norms by substantial margins. This is true with the so-
called technology stocks (or for that matter any stock), which in many cases tend to get excessively
discounted by the market-and then fail to realize that inflated potential. In such a situation, investors may
profit from selling out earlier than originally planned. And if the fundamental story is still intact, you could
even buy back your shares at a lower price. So stay tuned to any short-term movements in the stock
market that affect your stocks. However, if your goals are long term, don't get into the trading mode, where
you compromise on the big picture for some measly short-term gain. It is important that you still think long
term. As Benjamin Graham, author of the investment classic The Intelligent Investor wrote: "In the short
term, the stock 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.

" A trend may not be your best friend"

The psychology of the stock market is not only based on how investors form judgments about future
events, but also on how they react to the immediate past. There is a tendency among common investors to
buy shares of those companies or sectors that have performed well very recently. It is critical that you know
at where you are situated in the cycle during any bull run. That's because what may seem to be an
everlasting phenomenon eventually turns out not to be one. It will be replaced by another, equally
compelling one. And as an investor, you are left with shares bought at the peak of a cycle. The bull run in
steel and cement stocks during 1993-95 on the BSE was replaced by a rally in shares of fast moving
consumer goods companies in 1996-1999. This in turn was recently replaced by a mad rush for software
stocks.

Like Burton Malkiel, the author of A Random Walk Down Wall Street has to say: "It is not hard, really, to
make money in the market… What is hard to avoid is the alluring temptation to throw your money away on
short, get-rich-quick speculative binges."

Diversify, diversify, diversify

It is hard to imagine that a basic principle such as investment diversification can be so valuable. The idea
behind diversifying is to reduce your security-specific risk. So that even if a large company were to fail and
never fully recover, equity shareholders and bondholders do not suffer as much. By owning a broadly
diversified portfolio of stocks and bonds, only market risk or economic risk remains. Just make sure you
diversify both among asset classes (stocks, fixed-income and cash-equivalents) and within each class.
Spreading risk over a variety of investments should provide for more consistent portfolio return.

Time marches on

Time can dramatically enhance the value of your starting capital through the magic of compounding. At 10
per cent annually, the annual incremental capital accumulation on a Rs. 10,000 investment is Rs. 1,000 in
the first year, is over Rs. 2,300 by the 10th year, and just under Rs. 10,000 by the 25th year. After 25 years,
the total value of the initial Rs. 10,000 is Rs. 108,000, a ten-fold increase in value. Give your investment all
the benefit of time that you can afford. Choosing an investment plan that automatically reinvests your
dividends and interest is also a way to benefit from the power of compounding.

Evaluate yourself

A lot of investing is about your orientation about the future. We all make certain assumptions while
estimating our future needs, and how we intend to meet those needs. But circumstances can change.
Hence it is important that you review your portfolio at least once a year. Also try to evaluate the
performance of your investments against the level of risk you are assuming for achieving the returns you
want. And when necessary re-balance your portfolio to stay on track with your long term financial goals
Coming to Terms with Risk

Investing requires us to make a fundamental choice-- between eating well and sleeping well. If you want to
eat well, prepare yourself for the higher risks involved in search of a higher return. If you prefer to sleep
well, be willing to give up the higher returns for safety in exchange. But in either case defining risk only in
terms of the probability of losing money is not enough. Risk emanates from various sources and it is
important to understand how each type risk could relate to potential returns. This can help investors
improve their chances for greater wealth and more importantly, still not lose too much sleep over it.

Business risk:

It is the variability of a company's earnings before interest and taxes (EBIT). And is a combination of the
following: First, demand variability. If the demand for a company's product is not stable or predictable, its
revenue won't be stable or predictable either. Second, the company's ability to increase prices or absorb
cost increases, often the key to its profitability. Companies differentiating their products through branding
are better equipped to pass on cost increases and earn above average profits. Third, if fixed costs are a
substantial portion of total costs, business risk is definitely higher (unless such a cost also creates a strong
entry barrier) since a company's earnings then are more susceptible to variations in demand.

Credit risk:

Applicable to holders of debentures, it is defined as the ability of a company to pay the promised interest
on fixed-income instruments and return the principal on maturity. Rating agencies such as Care, Crisil, Icra
and Duff & Phelps evaluate and rate fixed-instruments of all types to help investors understand the extent
of credit risk. The quality of an instrument is better, if its rating is higher. A lower quality bond generally
pays a higher interest to compensate investors for greater credit risk. So when a company promises higher
rate of interest, remember it does so to attract investors (and not because it can afford a higher rate of
interest).

Exchange rate risk:

Risk arising from variations in exchange rate of the rupee versus the US dollar. Profits of companies who
import a relatively large part of their raw material are at risk if they are not able to fully pass on cost
increases when the rupee depreciates. A weakness in the rupee also prompts foreign investors to withdraw
from the stock market by selling their shares and converting those rupees into dollars. While they may re-
enter at lower levels, that stock indices tumble in the short-term is a big risk for the domestic investor.

Financial risk:

Interest being tax-deductible, equity shareholders welcome debt to the extent, it enhances their returns.
But beyond a point, they are exposed to the risk arising from a high level of fixed commitments. This
describes financial risk. It arises when debt represents a higher proportion of a company's capital structure
(comprises net worth and debt).

Industry risk:

It is the risk that applies to an industry. A large scale shift in demand, a rise in input prices, regulatory
changes are typical factors that would signify such a risk. For instance, a large-scale shift in demand
happened when popularity for cheaper polyester clothing affected that for cotton fabrics around 1990's.
Another example is the risk that is borne by Indian tyre companies when international prices of natural
rubber rise.

Inflation risk:

Inflation can hit a company's profits badly if it is not able to pass its effects to consumers. This trouble is
often faced by large manufacturing concerns and public sector units (since they also tend to be highly
unionized), through wage hikes that occur due to inflation. They are not easy to pass on. Even if inflation
eases, wage hikes can rarely be rolled back. Worse, inflation can inflate corporate profits through
overvaluation of closing inventory. When a company uses the FIFO (first in, first out; where the material
that is issued first is priced on the basis of the cost of material received earliest) method to value inventory
the charge to production is low in a period of rising prices. This can inflate reported earnings, increase tax
burdens and may prompt a higher dividend---consequently the company is sapped financially.

Interest rate risk:

Since they come with a fixed return, bond values fluctuate with changes in interest rates. When interest
rates rise, the value of an existing debenture goes down, as it is paying a lower rate than what investors
could earn elsewhere. When interest rates fall, the value of a debenture rises as they are now earning a
higher rate than what investors could earn from one that is newly issued. The longer the maturity of a
bond, the greater also it is vulnerable to an interest rate risk.

Management risk:

It is simply defined as the inability of the management to take decisions in the larger good of its minority
shareholders and the company. All decisions that benefit only a company's directors and its promoters
would classify as a management risk. But even a shareholder-friendly management can be a risk if it is
unable to manage a company's growth in both good and bad times. Also, if it lacks the necessary
dynamism to lead the company.

Market/Economy risk:

Risks that are not unique to a company, and that which stem from economy-wide factors such as money
supply, the level of government borrowing, the industrial policy, a global recession and so on. It is also
known as non-diversifiable risk, since investors cannot avoid the risk arising from them, however
diversified their portfolios may be.

Understanding Indices

Have you ever wondered why your first question to your stock broker invariably is --"How is the market?"

Why should an individual investor, even if he does not hold a single share in the stocks comprising the
Sensex, be bothered so much about one indicator. This line of thinking is not only evident at an individual
level but to brokers, traders, the media and institutional investors. Though people may believe that index
levels do not affect stock picking, rarely will you find them ignoring indices altogether. For the index is not
just a popular number but a snapshot of market behaviour. Hence, it is widely tracked throughout the world
to gauge the market moods. The BSE Sensex or the S&P CNX Nifty serves as a proxy for the market as
they represent a diversified portfolio of stocks.

Indices have uses other than just providing a market direction; they can be used to hedge one's portfolio,
speculate on indices themselves using futures or as index funds do, track them to spread investment risk.

Don't put all your eggs in one basket

Risk optimization is the primary objective of any investor, that is to maintain returns and lower risk. Since
an index represents a diversified portfolio of stocks, it cancels out fluctuations attributable to individual
stocks. Stock price movements are dictated by two factors. One is a company specific event like a closure,
strike, accident, bumper results which is referred to as non-systemic risk. The other is external events like
a flood, war or a global recession which is called non-systemic risk.

By diversifying, you seek to reduce the non-systemic risk by spreading your investments across
companies. Hence, an ideal index is expected to reflect only systemic risk, which cannot be reduced.

Importance of an Index

The index has practical applications too in the world of finance. Derivatives and index funds both make
extensive use of indices. Both the NSE and BSE have launched index futures based on the S&P CNX Nifty
and BSE Sensex respectively. The global market for index services and their applications is a multi-trillion
dollar industry.

Indices also serve as a benchmark for measuring the performance of fund managers and their respective
funds. For gauging the performance of individual sectors or sectoral mutual funds, sector specific indices
can be used.
Index Fluctuations

Theoretically, index fluctuations reflect changing expectations of the stock market about future stock
returns. An upward movement in the market index on a particular day implies that the stock markets expect
higher future returns from the stocks as compared to the expectations on previous day and vice versa.
However, since indices are derived from the market capitalization of stocks, it is quite possible that a few
stocks account for a major portion of the index. Thus, fluctuation inn prices of a few stocks may affect the
overall index too which will give an incomplete picture. Hence, it is advisable to follow a broad-based index
that is an index constructed using a large number of stocks spread across a wide range of sectors to
gauge overall performance. Also, an index should not consist of illiquid stocks in its portfolio since in such
cases, the index can be easily manipulated by manipulating the prices of such illiquid stocks. Construction
of an Index Most market indices are constructed using the value-weighted method. In this method, the
initial market value of these stocks is assigned a base index value. Say, we take the base year as 1982
and take 30 stocks which have a total market capitalization of Rs. 3,000 crore. Let us assume that the
base value on the first day is 100.

Suppose the market capitalization on the next day of these 30 stocks increases to Rs. 3,300 crore. To
calculate the index, you take that day's market capitalization, divide it by the base figure and multiply by
100 to get the new index. In this case it will be, 3300/3000 multiplied by 100 to get 110 points. Care should
be taken to distribute the stocks selected across a wide number of sectors so that the index is not skewed
towards a particular sector. An index which, is constructed using stocks belonging to a sector results in a
sectoral index. For example, an index comprising all software stocks will represent the software sector.
Such indices are useful for gauging the performance of individual sectors and sector specific mutual funds.

Types of Indices

The following are some of the major market indices:

Index No. of stocks Base Value Base Year

BSE Sensex 30 100 1978-79
BSE 100 100 100 1983-84
BSE 200 200 100 1989-90
BSE 500 500 1000 1999
S&P CNX Nifty 50 1000 1994
S&P CNX 500 500 1000 1994
CNX PSE Index 20 1000 1994
CNX MNC Index 50 1000 1994

PSE - Public Sector Enterprise, MNC - Multi National Company

In addition to the above, a large number of sectoral indices are also available to the investor.

The NASDAQ syndrome

The NASDAQ has become the most keenly observed stock market indicator in India, after the Sensex.
Attribute it to the growing importance of IT stocks in India's market or globalization of the Indian capital
markets. Fact is, at 5.00 AM in the morning, several people across the country switch on CNBC to find out
what the NASDAQ and the DJIA were up to.

Only two Indian companies are listed on the NASDAQ, viz., Infosys Technologies and Satyam Infoway (a
subsidiary of Satyam Computer Services). However, the valuations of these two stocks along with the
overall direction of the NASDAQ has a tremendous bearing on valuations of the infotech sector.

In fact, speculators and day-traders look at the NASDAQ levels to predict the direction of the local markets.
There is a high degree of correlation between the BSE Sensex and the NASDAQ particularly post mid-
1999 till date. However, long-term investors need to consider the following issues before blindly believing
in the NASDAQ effect. Take the case of Infosys wherein 3.14 per cent of its equity is listed on the
NASDAQ and its market capitalization on the NASDAQ accounts for only 6-7 per cent of its total market
capitalization. Ironically, it is this 3.14 per cent that determines the remaining 96.86 per of the equity listed
on the domestic exchanges.

Is this sustainable?

Infosys' stock price on the NASDAQ is largely determined by the NASDAQ’s overall direction which, in turn
depends on the large software companies, internet and biotech firms comprising the NASDAQ Composite
Index. However, Infosys which is predominantly a software services firm does not fall in any of these
categories. Thus, it is debatable whether the NASDAQ should determine the domestic price of the Infosys
stock.

The Sensex has been recently reconstituted which has resulted in a 40-50 per cent weightage to new
economy stocks. Hence the impact of the NASDAQ is bound to be substantial since these stocks follow
the broad directions emanating from the NASDAQ. Hence, but for the reconstitution of the Sensex in the
past, the correlation with the NASDAQ would not have been so strong.

The MSCI Connection

International securities firm Morgan Stanley has developed various indices to measure performance of
global securities markets. Of these, the most relevant to India are the MSCI Emerging Market Free Index
(MSCI-EMFI) and the MSCI India Index. The former includes emerging markets with relevant weightages
for each and the latter is an India dedicated index consisting of Indian stocks with appropriate weightages
for individual stocks based on their liquidity.

The MSCI-EMFI re-balancing on May 17, 2000, reduced overall weightage of India in the index from 9.08
per cent to 7.45 per cent, since the weightage of other emerging markets increased. In the MSCI India
Index, 14 new stocks were added while 10 stocks were removed.

The new stocks included Aptech, Digital Equipment (India), DSQ Software, Escorts, Essel Packaging,
Global Tele-systems, HFCL, Hughes Software, Jaiprakash Industries, Pfizer, Silverline Technologies, SSI,
Sun Pharmaceuticals and Zee Telefilms.

All stocks except Zee Telefilms were included at 100 per cent market capitalization while Zee Telefilms was
included at 60 per cent market capitalization on account of its lower free float. The stocks which, were
removed from the index included Arvind Mills, Bombay Dyeing, Essar Steel, Indian Rayon, Nocil, Reliance
Petroleum, Spic, Thermax and United Phosphorus. Inspite of adequate liquidity, the Reliance Petroleum
stock was removed from the index on account of the crossholdings with other Reliance Group companies.

Wipro's weightage was cut drastically from 100 per cent to 30 per cent of market capitalization, on account
of the very low floating stock in the company. The Wipro stock on the local bourses took the brunt of selling
and was locked at the lower circuit filter for at least three trading sessions after the revamp.

The exit of Reliance Petroleum from MSCI India Index prompted a bear hammering in almost all the
Reliance group stocks on the next day of the revamp. While Reliance Petroleum and Reliance Capital
scrips hit the extended 12 per cent lower circuit limit on the BSE, the group flagship Reliance Industries
was down by 9 per cent over its previous close.

Most of the stocks which, were introduced in the index were up strongly while those which, were removed
from the index were weak. However, it may be noted that most of the India-dedicated funds do not use the
MSCI India Index as a benchmark. It is mainly the emerging market funds, which use the MSCI-EMFI for
country-wise asset allocations. Hence, the immediate up-trend or down-trend observed in the stocks stated
above may have been a knee-jerk reaction to the MSCI recast with no major long-term implications on the
fundamentals of individual stocks.

The P/E enigma

One of the key determinants of a good valuation yardstick is its usage. The price to earnings multiple (P/E)
wins hands down on that score, being easily one of the most popular valuation tools not only in India but
across the globe. This article will tell you about the practical applications of the P/E multiple as a valuation
tool.
Why is that Reliance Industries --which has a net profit of Rs. 1,400 crore-- trades at a P/E of 15 times
while software companies who do not have a turnover of Rs. 1,400 crore trade at a P/E multiple of 100-150
times. Or take IOC as an example, which trades at a P/E of five times whose turnover exceeds that of all
software companies put together.

The answer to these questions can be found in differing investor expectations. These are expectations
regarding future earnings growth and prospects.

What is a P/E multiple?

Conceptually the P/E multiple represents the premium that the market is willing to pay on the earnings
based on its future growth. The ratio is most often used to conclude whether a stock is undervalued or
overvalued. The P/E is calculated by dividing the current market price of a company's stock by the last
reported full-year earnings per share (EPS). In effect, the ratio uses the company's earnings as a guide to
value it. The P/E thus computed is also known as the trailing or historical P/E since it uses the trailing
(historical) EPS in its calculations
.
A variant of the P/E - called the forward P/E - has also been developed wherein the current market price of
the stock is divided by the expected future EPS. The attempt to study P/E ratios in this manner reflects the
effort to factor in the expected growth of a company.

Since stock market valuations factor in the future expectations of the market, a P/E multiple computed
using historical earnings can at best be of academic value since it does not factor in the future growth in
earnings. It fails to capture events that may have happened after the earnings date. For example, suppose
a merger happens after the earnings have been declared, a P/E multiple based on the historical P/E will
fail to capture this event in the EPS whereas the price would reflect it, creating a distortion.

The forward P/E is popularly used to find out if the premium the market is willing to pay on the earnings is
line with the growth expectations. For example, the market price of Hindustan Lever on June 13, 2000 was
Rs. 2,497 representing a P/E multiple of 49 times based on calendar 1999 earnings. Assuming an earnings
growth of 20 per cent for the next year, the forward P/E for the stock would work out to 40.83 (49/1.2). This
means that the market is willing to pay 49 times the historical earnings and 40.83 times the future earnings
for each share of Hindustan Lever.

For an investor it makes much more sense to look at the forward P/E of Hindustan Lever for taking an
investment decision. Each investor would have his or her own expectations regarding the future earnings
growth. To that extent the forward P/E for a particular stock will vary from investor to investor.

Determinants of P/E

P/E multiples reflect investor perception regarding the company's future. The consensus of this investor
perception will then form the market perception. This perception is a function of various factors, like future
prospects, risk-return profile of the investor, holding period, quality of management and various other
macro economic factors like interest rates and inflation.

The P/E multiple would obviously vary from stock to stock based on investor expectations. Consider a
hypothetical example of Hindustan Lever and Infosys Technologies which, are quoting at about Rs. 2,500
(a P/E of 49) and Rs. 7,800 (a P/E of 180) respectively based on historical earnings. Based solely on the
market prices, Infosys looks almost 3 times more expensive then Hindustan Lever. Why should the market
be willing to pay 180 times earnings for Infosys and 49 times earnings in the case of Hindustan Lever?

Hindustan Lever has shown a steady growth of about 20 per cent in net profits for the past few years while
Infosys has, on an average shown a growth of 100 per cent in net profits. Now if we work out the forward
P/Es for both the stocks, assuming the same growth rates for the next year, the forward P/E of Hindustan
Lever works out to 40.83 and that of Infosys is 90. The gap between the two P/Es would further come
down as a longer time horizon is taken into consideration. Hence, in spite of, Hindustan Lever and Infosys
being market leaders in their respective industries, they attract different valuations based on the expected
earnings growth rates.

Take another instance of Infosys and Satyam Computers quoting at a P/E of 180 and 140 respectively.
Besides, differing expectations regarding future earnings growth for these companies, a portion of the
difference in P/E can also be attributed to the disclosures made by the management to their shareholders.
Hence, qualitative factors like transparency, quality of management also impact a stock's P/E.

Stock prices, in isolation do not give any indication whether the stock is undervalued or overvalued. They
have to be viewed along with with the company's future prospects to arrive at any conclusion. Generally,
higher the expected growth in a company's earnings, higher is the P/E multiple that it attracts in the
market. The time period used for P/E calculations depends on the investment horizon of the investor and
would be different for each investor. However, P/E multiples cannot be applied to loss making companies
since they do not have any earnings.

Price to Earnings Growth Multiple (PEG)

The PEG multiple is the latest tool used for valuation of the stocks in the new economy segments like
software, media, telecom and internet. Since these industries have largely been a play on future earnings
growth, the P/E ratios, which are computed based on historic earnings, projects an inaccurate picture of
the future. Hence the PEG multiple is used to aid the valuation of such stocks. The determinants of the
PEG multiple are the same as that of the P/E multiple since it is derived from the P/E multiple.
The PEG multiple has been devised as a way of finding growth stocks at a reasonable price. The PEG
divides the historical P/E ratio by the compounded annual growth rate of future earnings. Generally, the
compounded earnings growth is calculated using the forecasted earnings for the next two-three years.

For example, if Infosys is quoting at a P/E of 180 based on historic earnings and the compounded annual
growth rate of its earnings for the next three years is 60 per cent, then Infosys' PEG is 3. This means that
Infosys is currently valued at 3 times the combined worth of its next three years earnings.

The lower the PEG, the more attractive the stock becomes as an investment proposition. It is obviously
more appealing to buy a stock on a P/E of 20 whose earnings are growing at 50 per cent than to buy a
stock on a multiple of 50 whose earnings are growing at 20 per cent. As a thumb rule, stocks quoting at a
PEG multiple below 0.5 are considered, to be undervalued while that quoting beyond a PEG of 2 are,
considered to be overvalued.

What is fair value?

We all like bargains but, but few investors attempt to estimate a company's worth before buying a stock.
Investing requires the same discipline one exerts when purchasing a house, a car or even groceries,
literally. The problem arises when investors don't anticipate the amount of risk they are taking when
purchasing stocks that trade at high premiums to the intrinsic value of the business. Because buying
securities at over inflated levels can lead to serious loss of capital.

From a purely static point of view, the fair value of an equity share is a point of indifference. A price level,
below which you would buy the stock. Or a price level, above which you would sell the stock. Real life,
however, is more dynamic and as a stock investor, you are dealing with moving targets. Where stock
prices fluctuate madly, as much as eight or 12 per cent every day. Thankfully, the fair value of a company
does not fluctuate with the price of its share. It is important to understand this before you proceed with your
equity investments.

How to determine fair value?

A simple method is to use the price-to-earning multiple, where the price of a company's stock is divided by
the earnings per share of a company. Which makes sense since growth in earnings is a proxy for how well
a company is performing within a given market opportunity. However, as long-term investors we are
interested in absolute value, irrespective of how the stock market is currently pricing the company. Here,
the P/E loses relevance since it is will be continuously influenced by the demand or supply for a company's
stock on the numerator side.

Earnings per share, which represents the denominator side of the P/E, also may not help. Since all
earnings do not equal free cash flows. Most of it is ploughed back into the company via capital
expenditures. And as investors we are interested in the surplus cash (though this term has many
variations, it is loosely defined as the cash after providing for recurring capital expenditures plus
depreciation and taxes, the later being a non-cash charge), which can be returned to equity shareholders.

This dictum is codified in the discounted cash flow model. Which says, that the value of a stock is equal
only of the free cash flows it produces in the future, discounted back to the present. When you discount
future income, you essentially adjust for the fact that a rupee in hand today is more valuable than a rupee
to be received in the future because today's rupee can be invested elsewhere to generate a return. The
DCF allows you to discount incoming cash flows by a rate, which you believe equates the level of risk you
are assuming. This risk-adjusted value then is compared with the prevailing stock price to check a
company's investment worthiness. If a stock is said to be trading at fair value, it simply means that the
market is pricing it according to the value it represents. Otherwise, it could either be bought or sold short.
With minor modifications, the DCF can be used to value a range of companies, from those growing faster
than the economy to those growing slower, or matching the pace of the economy.

Limitations

However, like all other valuation models, the DCF too has its limitations. For decades it served analysts
and investors well until faced with the prospect of valuing companies in the so-called new economy
businesses.

Not that the basic premises of the DCF are under question, but how does one account for companies
where revenues are growing at a rate, which have a high element of surprise. And small changes in the
amount of information available can bring about large changes in stock prices. How does one come up
with an appropriate discount rate, which reflects the high level of technological risk for many such
companies?

How does the DCF model build in for a boost in valuation that comes when a company is taken over by
another? Or when Infosys' seemingly expensively priced stock becomes a relatively inexpensive form of
currency for acquisitions.

The inability to predict the fair value for these companies also causes their stock prices to fluctuate beyond
wildest imaginations. Limited free float also creates price distortions. To stretch it a bit, using the words of
John Burr Williams, who pioneered the concept of DCF: "They (the stock market) had high hopes for the
business, but no logical evaluation of these hopes in terms of stock prices. The very fact that the company
was one of the hardest of all stocks to appraise was the reason it sold at extravagant prices, for
speculation ever feeds on mystery, as we have seen before."

Hence distinguish between 'price' and 'value'

In the end, instead of grasping on the appropriate valuation for these companies, investors can caution
themselves by thinking more carefully in terms of 'price' versus 'value'.

Price is not value. Price is what you pay. Value is what you get in return for owning a piece of a company.
When you shop for a consumer durable, you don't pay the list price without being sure of the quality of the
product and consistency of its expected performance.

Similar issues should matter more while investing--the quality of management, nature of the company's
business, the ability of the management to sustain growth and so on. Alternatively, think about the return
that you will need to compensate for the investment risk given the quality of the management and the
nature of business. If you cannot see a company providing such a return over a longer term, do not invest.

When it comes to investing choosing a great company is only the starting point. In order to make a good
profit investors must buy the stocks of great companies at sensible prices.

Living with volatility

This article deals the whole issue of stock market volatility. Volatility as a term here means the extreme
wide day-to-day changes in the prices of quoted shares. But instead of quantifying volatility, we look at it
from the point of view of its source and why volatility will continue to exist. The idea is to help investors
avoid reacting emotionally to fluctuating prices and prepare them for potential turbulence.

Information:

The amount of information available on listed companies today and the spread of this information have
never been so great before. Prior to mid-1990's, the relative inaccessibility of information ensured that
stocks of even large established companies were out of sync with their fundamentals. Giving insiders a
chance to profit from such market inefficiency. Today with proliferation of television and Internet media,
stock prices are covered by the minute so that the movement in share prices becomes news by itself. So, a
small piece of positive or negative information can lead to large changes in the stock price.

Investor reaction:

Volatility in a stock price precedes the flow of information. But how various investors in the stock market
react to this information is often more important. Robert J Shiller, a renowned professor of economics at
Yale University attributes excess volatility to investor reactions that emerge from their psychological or
sociological beliefs, than those coming from good economic sense. According to him, substantial price
changes can be explained by a collective change of mind by the investing public which can only be
explained by its thoughts and beliefs on future events, i.e. its psychology.

Investor type:

Investors react differently to the same information. John M Dalton in his book 'How the stock market works'
says that risk averse investors might sell as the market becomes bearish, while more speculative investors
might sell short to gain high profits. Long term 'buy and hold' investors on the other hand might interpret a
market downturn as a chance to indeed buy low and hold to sell high. All this creates inefficiencies in the
market, which arbitrageurs in turn exploit to make a living. Unique preferences of each market participant
also add to volatility. Foreign investors for instance are keener to exit from stocks if the rupee is expected
to slip against the dollar. In the process of converting their rupees to dollars, volatility in the foreign
exchange market is transferred to the stock market. Institutional investors are known either buy or sell
large quantities of shares any company at a point of time. This itself can create an unusual swing in price.

Difference of opinion among fundamentalists and that among technical analysts as a group also lends to
volatility. The former relate prevailing prices to expected earnings to arrive at a judgment (or that price
should be the discounted present value of future dividends), while technical analysts depend on past
prices to predict future trends. Shiller, however, proved that fluctuations in prices are far too big to be
accounted by changes in expected earnings or dividends alone. This takes us to the next point

Market expectations:

Stock prices behave in relation to investor expectations about their future. More so in the case of the so-
called new economy stocks, valued solely on future expectations. So even a slight change in information
used to form those expectations can drastically the market's assessment about their worth. And since new
information is pouring everyday, it is constantly affecting stock prices. On the brighter side, investors can
profit from a high element of earnings surprise that these shares carry. Sheller’s latest book, 'Irrational
Exuberance', on the relative overvaluation of the stock markets in the US, provides another view.
According to him, millions of individual investors may be investing in stocks because they have seen the
success that others have had, and so their choice to do so is rational, but they may not actually performing
any real analysis or adding to the collective knowledge of stocks and their pricing. This logic could apply to
Indian stock markets too with investors betting on the next Infosys. So, expect volatility. Don't treat it as
unusual. Stay focused with stocks that clearly meet your objectives. Recognize that emotional reactions to
short-term market movements can hurt your long-term investment goals. Also, don't have unrealistic
expectations for the performance of their stock portfolio.

What is a mutual fund?

A mutual fund pools together sums from individual investors and invests it in various financial instruments.
Each mutual fund has its own investment objective, which broadly falls into two categories: capital
appreciation and current income. Suppose a mutual fund sells one million units or shares (used as
synonyms in this context) at Rs. 10 a share and collects a total Rs. 10 million. If the fund objective stated
investment in blue-chip stocks, the fund manager would invest the entire proceeds (less any commissions
and management fee) of that sale in buying equity shares of companies like Hindustan Lever, Reliance
Industries, and Hero Honda and so on. And each individual who bought shares of the fund would own a
percentage of the total portfolio only to the extent of money invested. The value of the fund's portfolio
would depend on how the shares of these companies perform on the stock market (given their financial
prospects). If the total market value of these companies (as reflected in the fund) increases to Rs. 12
million, then each original share of the fund would be worth Rs. 12 (Rs. 12 million divided by one million
shares). This per share value is what is known as the net asset value (NAV) of the mutual fund. It equals
the market value of all its assets (after adjusting for commissions, expenses, and liabilities, if any) by the
number of such units or shares outstanding.
How does one calculate the NAV and what does an NAV signify?

Net asset value on a particular date reflects the realizable value of a mutual fund's portfolio in per share or
per unit terms. It is the worth of an investment with an open-end mutual fund quoted in terms of its net
asset value. That is also the amount an investor can expect if he or she were to sell his or her units back to
the issuer. Daily closing prices of all securities held by the fund are used as a starting point. Subtract this
amount for liabilities (including expenses and commissions). And divide the result by the number of
outstanding shares and voila! You have the NAV. If the realizable worth of the portfolio is Rs. 12 million,
divided it by shares outstanding, let's say one million units, then the NAV is Rs. 12 (12/1). If a fund's NAV a
year ago was Rs. 10.5 and is currently Rs. 12, then your pre-tax return is 14.28 per cent ((12-
10.5)/(10.5)*100). An NAV signifies nothing more than the current worth of a portfolio. The NAV of a fund
only starts to make sense when compared to a benchmark index. First, it tells you the extent to which, the
securities that comprise the fund's portfolio have outperformed or under performed the index. Two, the use
of certain statistical measures can also tell you whether a fund was able to derive above-average risk-
adjusted returns. Having said this, a fund's historical NAV performance is not the best indicator of its future
performance. For equity funds, this NAV changes almost everyday with fluctuations in stock prices. While
the NAV of a fixed-income fund is driven more by changes in rate of interest. On its own, a rising NAV only
means that assets, which form a part of the fund's portfolio, are rising and vice-versa.

What is the difference between open-ended and close-ended schemes?

A mutual fund can be either open-ended or close-ended. The difference between the two is in the way
each operates after the initial public offering. A close-ended scheme operates like any other public entity
whose shares are traded on the stock market. Thus, to buy or sell the shares of a close-ended scheme,
you have to transact on the BSE or on the NSE. That's why the market price of its shares is also
determined by supply and demand for its shares (apart from quality and performance of its portfolio). On
the contrary, open-ended funds continue to price, sell and repurchase shares after the initial offer on the
basis of the NAV. The mutual fund is ready to sell additional shares of the fund at the NAV (at par or
adjusted for expenses), or buy back (redeem) shares of the fund at the NAV (at par or adjusted for
expenses). That's why the unit capital of open-ended funds can fluctuate on daily basis. But a close-ended
fund may or may not offer more shares after its listing. It may or may not also repurchase its shares. That
is up to the issuing company to decide.

Why do shares of a close-ended scheme trade at discount to its NAV?

It is important know that the NAV and the market prices of close-ended schemes are never the same.
Close-ended schemes always trade at a discount, from five to 50 per cent. What explains this discount?
And why does this discount differ from one fund to another? The discount is partly explained by the time
frame of investment. Most close-ended funds have a rather long time frame of investment, typically, five to
15 years (while some may never be redeemed). Which makes it impossible to predict the ability of the fund
to liquidate its portfolio at market prices or even close to market prices (since they often have large
holdings in companies). This discount, however, reduces (market price comes closer to NAV) as the fund
nears redemption. Or if it is being converted into an open-ended fund, where the pricing is on the NAV.
Otherwise, any other difference in the rate of discount from one fund to another has got to do with the fund
objective, quality of its portfolio and so on. If the stock markets view on the quality of its portfolio and the
fund's manager are positive, its share price will trade closer to NAV.

How safe are mutual funds?

As financial intermediaries, they do not come without risk. Also when defined in terms of your chances of
losing money, the risk in mutual funds is no different than that present in other financial instruments. Still
they are relatively safer and a more convenient way on investing. 1. With mutual funds you can control risk
by choosing a fund that given your risk profile, you believe is the best. On the other hand, picking stocks
individually that will both meet your objectives and match your profile can be tough. 2. A mutual fund
portfolio is also easier to monitor than individual shares. They also come without systemic risks (like bad
deliveries). They offer quick liquidity. Most private mutual funds can be redeemed in three to four working
days, unlike a fixed deposit that is more likely to be received a month after its maturity, or an equity share
after the end of its settlement period (or depending up on your broker). This too cuts the overall risk
associated with investing, often not so visible and hence not accounted by many investors. But the market
risk or the risk that exists due to economy-wide factors remains. And there is always the possibility that a
fund fails to stick to its pre-determined objectives or invests in securities that alter its risk profile. In which
case, the blame goes straight to the fund manager and the Asset Management Company (AMC), which
manages the mutual fund.

What is entry load and exit load?

The AMC that manages your mutual fund cannot also afford to bear all its expenses. So it recovers part of
this regular expenses from the investor, for whom it is doing this big favor. It is broken into two parts:
annual management fee (up to 1.25 per cent for funds less than Rs. 1 billion and one per cent for funds
above Rs. 1 billion) and entry & exit loads. Loads normally apply to only open-ended schemes. An entry
load is also called the sales load, which is mainly to help the AMC recover expenses relating to sales
literature, distribution, advertising and agent/broker commissions. The price at which an investor buys into
the fund is a function of both the NAV and sales load. For instance, if the fund's NAV is Rs. 12 and the
applicable sales load is 6 per cent, your cost of entry is Rs. 12.77 (12/(1-0.06)). If the investor applied for
Rs. 10,000 worth of units he would receive 783.085 units (10,000/12.77). On the other hand, exit load (if
you withdraw within a specified period) is charged while redeeming your units. The latter is for more logical
reasons, especially with income or money market funds, where a quick withdrawal by too many investors
can put pressure on the fund's asset maturity profile. So to ensure that longer-term investors are not
penalized, short-term investors are charged an exit load. But an exit load can also be applied by the AMC,
if it wants to prevent unit holders from selling their units. This happens when the fund has done poorly
against the benchmark index. An established fund can also manipulate investor entry into a fund by
charging or not charging a sales load. An AMC can charge a stiff entry load if it wants to prevent more
investor from pouring money into its schemes. However, that rarely happens. More often, the AMC
welcomes investors by advertisements screaming "no load" if invested within a certain time frame. Smart
investors have to recognize this tactic used by an AMC.

What advantages do mutual funds offer over equity stocks?

Here are a few considerations:

1. Diversification: Most mutual funds spread the money over 20 to 30 equity shares. This lowers the risk
from an investment loss. Even if any one or two shares were to under perform, their impact on the NAV
may be only restricted to their proportion of holding. You can't get much diversification from buying equity
shares of a company, unless you buy into a conglomerate. But then their shares are not exactly fancied by
the stock market.

2. Systematic Investment Plan: Small sums (starting from Rs. 500) of money can be invested monthly or
quarterly. This is not an option with equity shares. Shares or units of mutual funds are also available in
fractions (up to three decimals), while equity shares are traded in round lots only. A plan for systematic
withdrawals is also available from some funds.

3. Easy entry and exit: Filling a mutual fund application or a redemption form is all that it takes while
entering or exiting a mutual fund. But with equity shares, you need to have an account with a stockbroker
(for buying & selling) and another with a depository participant (which maintains your shares in an
electronic form). Some investors may find this cumbersome.

4. Reinvesting dividends: Funds provide for automatic reinvestment of dividends. In India, this facility is not
so far available with equity shares.

5. Tax benefits: Section 88 for Equity Linked Saving Schemes, ability to reinvest your proceeds from capital
gains into mutual funds under section 54EA & 54EB and tax-free status for equity oriented funds for three
years starting from April 1, 1999 is popular benefits that investors in mutual funds can avail of. (However,
you are advised to consult your tax consultant to find the exact nature of these benefits and who are they
specifically applicable to.)

6. Professional management: When you are investing in a mutual fund, professionals with experience in
fund and portfolio management are supposed to be taking care after your money. They presumably are
also monitoring the economy and the stock markets to adjust the fund's holdings accordingly.

What are the different schemes available under mutual funds?

The schemes or funds (often used synonymously) can be classified as:

1. Growth Fund: They promise pure capital appreciation with equity shares. They buy shares in companies
with high potential for growth (some of which might not pay dividends). The NAV of such a fund will tend to
be erratic, since these so-called growth shares experience high price volatility. They also make quick
profits by investing in small cap shares and by investing in initial public offerings of small companies.
However, growth strategy may differ from one fund to another. Not all growth funds operate similarly.

2. Income Fund: They aim to provide safety of principal and regular (monthly, quarterly or semi annually)
income by investing in bonds, corporate debentures and other fixed income instruments. The AMC in this
case will also be guided by ratings given to the issuer of debt by credit rating agencies. Wherever a debt
instrument is not rated, specific approval of the board of the AMC is required. Since most of corporate debt
is illiquid, the fund tries to provide liquidity by investing in debt of varying maturity.

3. Money Market Fund: Also known as Liquid Plans, these funds are a play
on volatility in interest rates. Most of their investment is in fixed-income instruments with maturity period of
less than a year. Since they accept money even for a few days, they are best used to park short-term
money, which otherwise earns a lower return in a savings bank account.

4. Gilt Fund: They are aimed at generating returns commensurate with zero credit risk, that is by investing
securities created and issued by the central and/or the state government securities and/or other
instruments permitted by the Reserve Bank of India. Since they ensure zero risk, instant liquidity, tax-free
income, their return is lower than an income fund.

5. Balanced Fund: The idea is to get the best of both the worlds equity shares and debt. Investing in
equities is supposed to bring home capital appreciation, while that in fixed income is to impart stability and
assure income for distribution. The proportion of the two asset classes depends on the fund managers'
preference for risk against return. But because the investments are highly diversified, investors reduce
their market risk. Normally about 50 to 65 per cent of a portfolio's assets are invested in equity shares.

6. Sector Fund: The goal is once again pure capital appreciation, but the strategy is to buy into shares of
only one industry. And not diversify like a growth fund. Such funds forgo the principle of asset allocation for
high returns. That's why they are also the riskiest.

7. Tax Plan: Also known as Equity Linked Saving Schemes, they operate like any other growth fund (and
that's why are as risky). However, an investor in these schemes gets an income-tax rebate of 20 per cent
(for a maximum of Rs. 10,000) under section 88. Essentially an incentive for the investor (who is otherwise
investing in fixed-income instruments like the Public Provident Fund primarily for saving tax on his or her
annual salary or business income) a chance to participate in capital appreciation that can be delivered by
investing in equity shares. That's also why these schemes also come with a three-year lock-in period. Also
while other tax planning schemes guarantee returns, an ELSS offers no such assurance.

8. Index Fund: Their goal is to match the performance of the markets. They do not involve stock picking by
so called professional fund managers. An index fund essentially buys into the stock market in a way
determined by some market index (BSE Sensex or S&P CNX Nifty) and does almost no further trading.
Index funds are optimally diversified portfolios and only carry along with it the due to economy-wide
factors.

But remember that the term 'growth' is often used in a very generic sense to denote every equity mutual
fund. Also 'growth' in fixed income funds, comes from reinvesting dividends. That's why in such fixed
income funds, investors have an option, they can choose either growth through reinvestment of dividends,
or regular income by ticking on the income option. If you understand the types of funds, you should have a
decent grasp on how funds invest their money.

How does one choose the right fund?

A few tips:

1. Acquaint yourself with the fund manager's investment philosophy. Compare the returns he or she has
generated on funds previously managed against funds with similar objectives. Both the experience of the
fund manager and the results of the experience are important.
2. Recognize the risk that emanates from an investment style. An investment philosophy and an
investment style are distinct from one another. A philosophy has got to do the overall logic of picking
stocks. That may not differ substantially, but an investment style can. For instance, within a given
philosophy, one fund manager may believe in taking large concentrated bets on stocks, while another may
prefer to diversify. The former is certainly a riskier style.

3. Lastly, figure out whether the fund's investment objective and style suit your risk profile. The latter is a
function of your investment time horizon, knowledge of capital markets, current net worth and future
income, emotional makeup to accept losses and so on.

When to buy, sell a stock- an FAQ

The share price of company ABC has dropped to Rs. 225 from Rs. 630. Is it a good buy?

Maybe. Buying stocks just because they look "cheap" is not always a good idea. Often they may become
still cheaper later. Using technical analysis, there are ways to determine whether a stock, which has fallen
a certain percentage from its peak is a good buy or not. One way is to wait for Company X to show that its
decline has been stemmed and is showing some signs of support. Thus, you can pick the stock up for Rs.
200 to Rs. 250 whereas earlier you might have paid Rs. 300-350 for it. A fundamental approach would be
ascertain the fall in the stock price has got to do anything negative with the company's operations. And buy
it only if prospects remain as solid as they seemed when the stock was trading at its peak. Investors can
also use a mechanical approach to buy stocks. Like purchasing an equivalent amount worth of stock every
week or every month. Thereby, you not only average your purchase price, but also ensure that you buy
more of the same stock at a lower price. This ensures that your average purchase price is closer to the
bottom, predicting which is anyway difficult

I would like to sell some shares as I am gaining handsomely, but I don't want to pay taxes on these.
What should I do?

Sell the stock and pay your taxes too. If you have made profits then the government would obviously like to
have its fair or unfair share of it. On the flip side, you would not have to pay taxes when you do not make
any profits.

My recent investment has appreciated a lot and I want to sell it exactly at the top. How can I do
that?

If anybody knew how, they haven't told us yet. Some technical indicators such as the relative strength
index can be helpful in locating approximate peaks. A fundamental valuation tool such as the price-to-
earnings multiple can also help if you compare the current P/E multiple with the stocks' historical P/E
range. If you look at price charts you will realize that seldom do peak prices last for more than a few days.
That is also the time when optimism for the stock is at high. But if your shares are in the demat form, you
can start selling in small lots. This way you at least don't miss a selling opportunity, especially when a stock
appears to be overvalued.

Are there any guidelines for selling when you are in the profit zone?

No. While technical analysis can help you to determine whether a stock is in an overbought or an oversold
zone, it is important that you set your own price targets and stick to them, unless there is strong reason to
not to do so. If price are fluctuating wildly, one rule you can follow is to use a stop loss, that is decide a
level at which your broker is automatically instructed to execute a sell order. But remember that most
investors invariably end up selling either too soon or too late. If you sell too soon, you may miss out on a
substantial up move. And then there is always the temptation to undo the regret by buying back at a higher
price, hoping that the stock will go higher. If you sell too late, then you are probably selling it because you
panicked.

Stocks often drop excessively on just a little bit of bad news. What gives?

One explanation is the "cockroach theory". If you see one cockroach, there are probably a lot more around.
If one piece of bad news gets out, the fear is that more bad news is lurking around the corner. Similarly, if
one stock in a sector gets into trouble (especially if it is an event that could easily happen to any other
company in the same business), there is a suspicion that others too will suffer. Example: Investor
confidence in internet companies took a beating after March 2000, when popular pure net plays in the US
such as CDNow.com faced bankruptcy

I read favourable news about company XYZ in the paper today. Should I buy the stock?

You will probably end up being the last in the queue. Everyone read that news, and the stock price has
probably already reflects that news. In fact, stock prices tend to drop on a major news announcements
following the old jungle saying: "Buy on rumours, sell on news."

Since I invest for the long term can I simply ignore the short term?

It is true that a 'buy and hold' strategy is superior to one that is based on market timing. But that does not
mean you wait for all negative developments to emerge before reacting. Hence, you need to look for
positive or negative signals in the short term, which if continue for some time may have long term
implications. However, avoid the temptation to profit from short term price swings. It may happen that you
decide to sell stock ABC at a price hoping to cover it later at a lower price. But then if the up move is
happening for some sound fundamental reason, you will end up losing. Similarly, it may also happen that
you cover up your position at a lower price only to see the stock price fall further as the share may have
been downgraded for a genuine reason. It is important that you do not miss the big picture.

How can one take advantage of general fluctations in stock prices?

If you think the market is "too high", you might give a stop loss to preserve profits, liquidate some of your
positions to capture profits and reduce exposure or delay any new purchases. If you think the market is
"too low", then you might keep some money aside for fresh purchases or cover your position, if have sold
the stock short before.

Do I base my buy and sell decision on the basis of the performance of an index?

Maybe. An index measures the market direction and in the process tells us whether most stocks are
moving up or down. Are two or more averages (like the BSE Sensex and the NASDAQ) moving in unison
or are they showing a divergence? It is important to know that most of an upward move or a downward in a
stock price is strongly linked to an index. Either a broad market index like the BSE Sensex or a sector-
specific index like Mindex (from The Economic Times, it represents knowledge-based industries). How
strongly is a stock's price influenced by an index can be determined by calculating its beta. So one strategy
is to locate a rising group in a rising market based on beta. Otherwise, look for sound companies in the
group, which have not risen yet and purchase one or more of them. The assumption is that the "best"
companies have already been bid up to full value and that some of the remaining will be bid up. Avoid the
poorest companies in the group since they may not move at all. Track indices to gauge the broad market
trend or use it as a benchmark to compare the performance of your portfolio. Alternatively, invest in an
index fund if you are not confident of beating an index by picking stocks on your own. It is a type of a
mutual fund that closely mimics a given index.

How to decide the right time to buy or sell an equity mutual fund?

Buying or selling an equity mutual fund is almost akin to buying or selling an individual stock. Because a
mutual fund represents a group of stocks (from the same industry or from various sectors as may be the
case), it cannot consistently perform better than the general stock market. Unless backed by some astute
stock picking on the part of the fund manager. Though considerations like tax or load might influence the
timing of your decision. Otherwise, reasons more specific to the fund such as a change in the fund
manager, or a change in the fund's objectives, lack of disclosure and so on will also strongly influence your
decision to either stay invested or exit from an equity mutual fund.

Inflation, Interest rate and the markets

Interest rates and inflation are not only important economic variables but also play a significant role in
stock market valuations.

If some one were to tell you that interest rates and inflation can affect stock market valuations, does it
strike you as being farfetched? After all, how can these two variables which are generally the favorites of
economists and the like affect the real world of stock markets. Well, both variables have an impact on
money and its cost to the user (of money) which in turn affect corporate performance as a result,
investment decisions. Even you can track these factors without too much difficulty: Just keep track of how
your bank fixed deposit rates and the Wholesale Price Index which appears periodically in newspapers
varies and you can have a fair enough idea of where they are headed. Chances are that your conclusions
will mirror what respected economists say, with a slight error margin.

Why Alan Greenspan's lips get so much attention…

Coming back to the markets, whenever there is a change in interest rates or the reserve requirements of
banks, there is an immediate impact on the market. Based on its view on inflation in the economy,
tempered with the need to foster industrial growth the Reserve Bank of India makes adjustments in the
monetary policy. Interest rates and inflation are two of the most important economic indicators affecting the
stock markets throughout the world. But why are economic parameters like interest rates and inflation so
important for the stock markets? Why does the NASDAQ catch a cold every time Alan Greenspan
(chairman of the Federal Reserve) sneezes?

Interest rates are one of the most critical determinants of corporate performance. Higher interest rates
adversely impact corporate performance and consequently valuations. Interest rates determine the
borrowing cost of companies both for funding incremental growth and for expansion. Since the financial
risk of a company increases in a rising interest rate environment, equity investments become riskier. To
give an example, say a company was earning Rs. 130 million as profit before paying interest and its
interest cost was Rs. 13 million. Suppose its interest cost was to increase by 20 per cent, then its profit
would be down by Rs. 26 million. Since the risk-return profile of investors undergoes a change, their
expected returns from the stock market and stocks in particular goes up. The universal logic is that higher
the risk returns too should increase commensurately. Also, rising interest rates means your fresh
investments in income funds and debentures earn more. Hence, the temptation to shift to debt instruments
from equities.

From an industry perspective, an increase in interest will result in higher costs. Companies will seek to
pass on these costs to users at the risk of affecting demand. Another threat is consumer demand getting
affected by higher interest rates as loans become expensive. This holds good for sectors like consumer
durables and automobiles where consumer finance is a key factor. We have seen how interest and inflation
rates can affect the stock markets directly in terms of affecting the risk-return relationship and indirectly by
affecting corporate performance. This pattern also reveals itself in the form of a measurable linkage
between inflation, interest rates and stock market valuations.

Empirical evidence

Interest rates and stock valuations share an inverse correlation. This is what we concluded based on a
study of interest rates in the economy as measured by the average prime lending rate and market P/E as
measured by the average P/E multiple of the BSE Sensex. Thus, when interest rates fall or remain steady,
the average market P/E moves up and vice versa.

For our purpose, we have taken interest rates as measured by the prime lending rate and market P/E as
measured by the average P/E multiple of the BSE Sensex. A study of the movements of interest rates and
the market P/E has shown a negative correlation of 0.6 between the two variables. That translates to 60
per cent of the variation in the average market P/E being attributable to the variation in interest rates in the
economy.

However, it has to be kept in mind that interest rates and stock valuations themselves are a function of
various factors. While interest rates are affected by the demand-supply of money in the economy, stock
valuations are affected by company specific factors like quality of management, competitiveness of the
company, demand for the company's products and so on. Hence to that extent the impact of such factors is
also reflected in the study stated above. Also, the impact of rising interest rates on corporate performance
is visible with a time lag of approximately 6 months. This is because generally it is only the fresh
borrowings of the corporates, which will attract the higher interest rates.

Inflation

Central Banks worldwide share a phobia for high inflation rates. They start raising interest rates when
inflationary pressures start building up, that in turn has an immediate impact on the stock markets. For e.g.,
preliminary indications of higher inflationary pressures prompted the US Federal Reserve (The American
Central Bank) to raise interest rates at periodic intervals in the recent past. The impact on the stock market
was almost instantaneous with the NASDAQ crashing by almost 2,000 points from the 5,000 levels in the
last 3 months.

A study on the correlation between the inflation rate in India (represented by the percentage change in
average wholesale price index) and the average price earning multiple (P/E) of the stock market has
showed that there is an direct correlation between the two variables. This means that when inflation rate
moves up, the average market P/E moves up and vice versa.

Our study on the movements of the inflation rate and the market P/E has shown a positive correlation of
0.59 between the two variables. This means that about 59 per cent of the variation in the average market
P/E can be attributed to the variation in inflation rates in the economy. However, as discussed above, it has
to be kept in mind that inflation rate and stock valuations themselves are a function of various factors and
to that extent the impact of such factors is also reflected in the study stated above.

Practically, the relationship between the inflation rate and the stock market follows the overall economic
cycle. The most important determinant, which affects both the inflation rate and the stock markets is the
Broad Money Supply (represented by M3). Generally, M3 is defined as the total amount of money supply
available in the economy.

It is a well accepted fact that when M3 increases, the inflation rate also moves up in the immediate future,
since we have a situation of more money chasing the same amount of goods/services in the economy.
Higher M3 also imparts extra liquidity to the stock markets since, the excess money is channelised into the
stock markets, thus pushing up the market P/E. Hence, stock valuations move up as an immediate
reaction to an increase in M3.

However, a prolonged phase on higher M3 gives rise to inflationary pressures and has an adverse impact
on the economy in the long-run. Hence, Central Banks, world over consider inflation (or money supply) as
one of the most critical parameters for the economic health of a nation. Generally Central Banks curtail
money supply (by raising interest rates) to rein in inflation, in the process reduce liquidity in the stock
markets thus adversely affecting stock valuations.

However, a prolonged phase of lower inflation gives a boost to the economic health of the nation and the
stock markets, which in turn increases the purchasing power of the consumers, thus raising the overall
consumption levels of the nation. The increase in consumption translates into higher prices if the nation is
not able to satisfy the increasing demand for goods and services. This again gives rise to inflationary
pressures and the entire economic cycle is repeated again

Hence, generally the relationship between inflation and the stock markets mimics the economic cycle of
the nation.

What is technical analysis?

Technical Analysis is the study of market action, principally through the use of charts. Market action is
expressed through movement of prices and the volumes which accompany them. Prices and volumes are
therefore the only two variables to be studied when using technical analysis. Technical analysis is the art of
interpreting stock price movements. Since financial market analysis involves some degree of subjectivity,
all of them are therefore an art and not a science (which involves exact rules being met under all
circumstances).

Does it have any chance of working at all or is it just like reading tea leaves?

Is the Pope a catholic? Does the sun rise in the east ? On a more serious note, folks, this is a question
asked more out of ignorance. Since technical analysis addresses the market, it is actually studying the
effect of action by all kinds of players. We know it to be a simple stated fact that all effects are rooted in
some cause. The simple premise is, everybody knows something about something, but the market knows
everything about everything. Because the market is the sum total of all the players. Hence the market is
the true reflector of all news and views of every conceivable player. Close study of effects will reveal a
consistent pattern which remains consistent through time. A good understanding of these underlying
dynamics of market behaviour will ensure that it works all the time.
Still, why does technical analysis sound so esoteric?

Mainly because there has not been a structured way of imparting this knowledge to people. The methods
originated in the West and it was not until recently that information about technical analysis was at all
available in India. Since it deals with an entirely new subject, it has a jargon of its own which is unlike what
we encounter normally in the markets. Hence the feeling of an esoteric subject. Other reasons such as
ignorance, unavailability of information, no formal learning structure and a general resistance of people to
change are also why the subject has remained relatively unexplored

I am a fundamentalist. Should I know anything about technical analysis at all?

Fundamental analysis addresses all variables outside the market whereas technical analysis deals with
variables within the market. The objective of both forms of analyses is the same - it is to find future
direction of stock price movements. Only the means of achieving the same differs. One of the major
advantages in learning technical analysis is that it enables one to deal with market risk - this is one
important area which is completely ignored by fundamental analysis. In a statistical study done by Purdue
University in the United States, it was found that the major risk faced by investors were - in order of
importance - market, sector and stock. It is only technical analysis which can give one an insight into
market risk. Hence a good knowledge of both technical and fundamentals would produce a more rounded,
well informed, investor.

Successful investors like Warren Buffet don't seem to rely on technical analysis.

Every person in the market should choose his own style of investing. People like Buffet are players over
the very long term. This may sound easy and acceptable but in practice, is a very difficult job to do. Not
many of us have such commitments to the very long term. Indeed, instant gratification is almost the buzz
word in the markets! Warren Buffet notwithstanding, it can be very conclusively proved that a proactive,
market timing based investment model will consistently outperform a mere buy and hold strategy most of
the time. There are always exceptions to any rule. From millions and millions of investors the United States
could still produce only one Warren Buffet or one Peter Lynch. They are the exceptions rather than the
rule.

Does technical analysis work as well in Indian markets as it does abroad?

Since technical analysis deals with the market and not geographical areas, it will work in any free trading
financial markets anywhere.

Aren't technical analysts like economists?

None of them seem to ever agree on anything. Since analysis is an art rather than a science, every form of
analysis, including technical and fundamental and economics (and maybe, even tea leaves!!) would leave
considerable room for individual interpretations. Non agreement is therefore something quite common.

As an aside do you know what they say about Economists ?

Well, they make the weatherman look Good!! If everybody relied on technical analysis, wouldn't their
collective actions itself distort the market? The market is always residing in the future. Any form of analysis
or method which seeks to project future direction of stock prices will develop a sense of self fulfillment
periodically, especially over the short term.. However, this in itself, will set up a corrective cycle as human
emotions of greed and fear will compensate for the seeming mass action. Hence such distortions would
remain only over the very short term.

There are so many theories in technical analysis. How do I know which one works the best?

The many theories in technical analysis are all the result of consistent and ongoing work in the subject. In
essence, they are a series of different ways of looking at the same set of variables - price and volume. It is
a bit like a jigsaw puzzle. Each different view point is a piece which when finally put together produces a
complete picture. There really isn't one method which would work all the time in all the market conditions.
One has to pick and choose the method to suit the market, sector and stock.
Is technical analysis and charting the one and the same thing?

Charting is really one element in technical analysis. The title is a bit of a misnomer, actually. John Murphy,
renowned author in the subject has put it better, calling it Visual Analysis rather "technical" analysis. One is
really addressing the market as a whole and therefore one is actually analysing the action of so many
different types of investors. A technical analyst is therefore doing something beyond only charting the stock
prices. He goes into the very minds of people involved through the medium of the charts.

Can I create my own charts or own technical indicators?

Consistent development in the field of technical analysis ( or indeed any field for that matter) occurs
because people manage to get out of straight jacketed thinking and begin cutting radical new paths.
Without original thought, there can be no further progress. Hence there is really no limit what one can
create.

I have no idea about technical analysis. Where can I learn technical analysis?

Fortunately today, the availability of information on the subject is considerably more than what it was some
years ago. This in itself, testifies to its growing popularity. Books are available from some of the leading
book stores in major metros. They are all by foreign authors of course. Yet. There hasn't been a book
authored by Indians as yet. On an average, these books cost about $25 and upwards. The books range
from simple introduction to going as far as complex subjects like Fourier transforms and Maximum entropy
to highly statistical models of risk assessment and asset allocations. Some of the simpler and more
popular books are published locally by Vision Books. Regular training programmes are conducted by UTI
Institute of Capital Markets, Vashi, New Bombay and by many private individual consultants. Once one is
more informed on the subject, one can keep abreast through specialised magazines like Futures and
Technical Analysis of Stocks and Commodities, which are published in the US.

Average your purchase cost

How many times have you cursed your luck for not buying shares of Infosys Technologies when it was only
Rs. 400? Then again, you could have bought it for Rs. 1,200 and even at Rs. 2,000. Sounds familiar? As
common investors, we all remember not having bought a particular share when it was cheap. Well, all's not
lost. Before you spot the next Infosys, here's a method to make sure that you don't miss the shares you
buy. It even helps you to keep low your cost of purchase. It is called dollar-cost averaging (rupees for us).

It is an easy technique (but requires discipline) in which a person invests a fixed rupee amount on a regular
basis, usually monthly for purchase of equity shares. Let's say you have a monthly surplus of Rs. 5,000 to
invest in equity shares. This can be used to buy shares of 10 shares of company ABC at Rs. 500 per
share. Or six shares of company ABC at Rs. 500 per share and eight shares of company XYZ at Rs. 250
per share. You could do this every month with the same companies or you could even expand the list of
companies. The choice is yours.

The idea is to invest a constant amount in a few selected shares over a longer term. And not a lump sum.
To continue with the above example, you could have invested Rs. 30,000 at the end of the sixth month,
instead of a monthly Rs. 5,000. But that would not have allowed you to lower your cost of purchase. To
benefit from fluctuating share prices, it is better to invest smaller amounts of money. Since more number of
shares can be purchased when prices are low. But when share prices move up, a fixed amount will buy
lesser number of shares. It turns out that this method will keep your average cost lower than the prevailing
market prices.

Assume that you had bought 10 shares of ABC at Rs. 500 in the first month and seven shares in the
second month as its price moved up to Rs. 650 (5,000/650 rounded off to the lower denomination). Your
average price would have been Rs. 561.76 (9,550/17), leaving you a profit 88.23 per share (650 minus
561.76) or Rs. 1,500. But if you had put off the purchase to the next month when you have a lump sum Rs.
10,000, you end up buying 15 shares (10,000/650 rounded off to the lower denomination) at Rs. 650. Your
gain by using the cost averaging method: two shares (17 minus 15) at Rs. 650, that is Rs. 1,300.

Remember that a stock prices often fluctuate for reasons unrelated to its fundamentals. With fixed rupee-
cost averaging, an investor eliminates his or her chances of buying too many shares at too high a price.
Periodic declines in a stock market give opportunities to buy at lower prices.

A few do's and don't:

1. Be sure that you have a steady stream on income. If income if not steady as expected, it would curtail
purchases at times attractive for additional purchases.

2. Make a short list of the shares that you want to buy. Run this method over at least six or seven stocks,
since one of two stocks will end up disappointing.

3. If fundamentals change, get rid of your under performers.

4. Don't try to time your purchases. That could turn you into a speculator instead of an investor.

5. If you think share prices are too high, don't purchase. Or buy stocks that you believe haven't yet
appreciated.

6. Lastly, don't hesitate to liquidate your portfolio before the your target time horizon, if circumstances lead
you to believe so.

The rupee-cost averaging method is quite similar to a systematic investment plan, which all mutual funds
tout. They work like this: After an initial minimum investment (ranging from Rs. 500 to Rs. 10,000
depending on the type of fund), an investor is supposed to hand over post dated cheques for the next few
months to the AMC (amount could range from Rs. 500 to Rs. 5,000). But be warned, that none of these
approaches can save you in a declining market (in fact, you could end up buying more and more shares in
a falling market).

TECHNICAL ANALYSIS

THE MECHANISM OF PRICE ACTION.

The common perception of Technical Analysis is that it is a tool for traders. That one gets short term
signals and therefore its usage is restricted to short term trading, possibly, only intra day trading even. How
did this perception emerge ? And how does this persist to this day ? This and a few other questions are
what we shall attempt to answer in this write up.

The answer to the first question is a bit round about. Most people attempting trading know that the price
moves change directions frequently and that fundamentals of a company cannot change with such
frequency. Ergo, the moves of the stock, intra day or over a small time frame have therefore to be
necessarily "technical" in nature. Since no one has quite bothered to explain cogently why prices do indeed
move over the short term or within a day, the image of "technical" movements have persisted.

So what indeed is this "technical" movement of prices ? Pause a minute and think of the answer. You may
not really get one. That’s because the prices are, well, just there and happen all the time, don’t they ? But
what is the price, really ? If we think of prices then we immediately think of supply- demand. All of us know
that prices are a result of the supply-demand equation. Let us therefore go up one more level and see what
produces supply or generates demand for stocks ? Well, here again, the answers should be pretty quick.
Our inkling of whether stocks are going cheap or expensive at the moment as compared with what they
may do in the future.

This leads to the next question, then. How does one get inkling of whether a stock is cheap or expensive ?
You would probably answer, depending on the "fundamentals" of the stock. So, what are the fundamentals
of the stock ? Ready answer, again. Sales, Profits, Products, Management, Earnings, Growth……. and
then you slow down, think a while, and come up with, Industry, Position within the industry, Competitors,
Finished goods, Raw materials, inventory, cash flows…… and then you think some more, and say,
Economy, International competition (if applicable), political atmosphere, stability of government. By now,
probably you have run out of items to list. Are you sure this is the full list of items, which affect the
fundamentals ? Probably, is your answer.

Ok, let’s take that as the list for now and examine it. Do you see a problem here ? There are about a dozen
factors in there, each of which comprises or is dependent on a dozen other factors. Many of these are
themselves further interdependent. More. Many of these factors require collection of associated data
before one can attempt to analyze them. So, in a nutshell, fundamental analysis faces two very important
factors. One, collection of all relevant material necessary for analysis. Two, and this is much more vital, our
ability to analyze the collected material.

Who can do a good job of it ? Obviously, some large funds who have both the access to information (they
can pay for it) and the ability to analyze (they can hire many analysts) and other larger players. What about
small guys like you and me ? Well, we try to do our best, don’t we ? We read some magazines, try to get
hold of a balance sheet or two, try our rudimentary knowledge of financials and come up with the best
scenario that we can. Is this going to be correct ? Who knows ? We just hope that it is.

So what we have in the market is a collection of people who have all done some kind of analysis on stocks
depending upon their access to material and their ability to analyze the material. All of this analysis leads to
a perception of future value and this perception is then compared with the existing price to see whether of
not a profit opportunity exists.

When you get into the realm of perceptions, you leave the comfort of rational numbers and enter into
another domain, which is dominated by an entirely different set of factors. This is the domain of one’s own
mind. Your perception of stock A would change from moment to moment, day to day or month to month …..
depending upon what your mindset is currently and what are the experiences you are undergoing at the
moment. The mind waxes and wanes from moment to moment and therefore perceptions of value too
change from moment to moment. So what was looking extremely attractive last week, suddenly is no
longer so this week because you suffered a loss elsewhere. Or your sister is about to get married and you
need the money. Or the government is shaky. Or there is a big drop at the NASDAQ. Or the FII selling is
relentless. Or. Or. Or. So you, who were on the demand side last week, are suddenly on the supply side
this week.

Get the picture here ? There are so many reevaluations taking place in our own minds and there are so
many of us out there in the markets - whether investors or traders or mutual funds or FIIs or hedge funds.
All are trying to make valuations, develop perceptions and then, finally express those perceptions through
the supply or demand mechanism. Is it any wonder that the prices keep on fluctuating back and forth as
these multitudes of valuations keep being expressed ? Remember, there is only one turf for all of us to
express ourselves – the stock market. So starting from a big daddy FII right down to the ubiquitous
Mr.Shah, we are all playing out our hopes and fears and greed and other associated emotions in the
market.

And what do we all express it through ? The Price, of course. This therefore is the one medium which
unites one and all within the market place. Outside the market, we may be small and big, in terms of
resources, access and ability. But within the market, our actions are pretty focused and are directed only
through movements of price. The price of day is therefore the sum total of all the known news and all the
known views upto that day. Think of it this way. If you knew something which others did not would you not
be in the market, either demanding or supplying the stock ? Would this volume not affect the prices ? If you
were bullish, you would be willing to pay a little premium so that you would not miss out on a good thing,
so the prices would rise. If your news was bearish, you would be willing to offer a discount to the current
rate so that you can get rid of the stuff fast before the rest of the market comes to know, so the prices
would dip. Hence price is that equilibrium point where all known news and views – both bullish as well as
bearish – have met and expressed themselves.

Price movements expressed over time are what define the Trend terms. The logic for the price moves
however remains consistent over all time. Hence it is our own misconception that price moves over the
long term are "fundamental" in nature while price moves over the short term are "technical" in nature. In
reality, they are just price moves, nothing more. It is our own erroneous labellings which get us into all
kinds of unnecessary imbroglios about the market. We will examine more such misconceptions later on in
this series.

Equity Investing --an Introduction

In stock investing, the number of choices he or she has does not limit an investor. Yet making the right
choice given one's age, income level and the ability to take risk, is often tough. Since every stock could
represent a unique risk-return opportunity. And just as investors are classified as conservative, moderate or
aggressive, companies too are broadly categorized into cyclical, defensive, growth, speculative and value.

After all, one would not consider State Bank of India to have the same investing characteristics as Infosys
Technologies. The SBI stock is a play on the Indian banking sector and the economy at large. Hence could
attracts longer-term investors. On the other hand, investors in Infosys could typically be more of those
seeking higher returns in software exports for a little more risk, and more concerned about the company
quarter to quarter earnings. Hence, some understanding of the different types of stocks is required to avoid
unnecessary risk.

Cyclical:

It is a company whose earnings tend to fluctuate sharply with the changes in business cycle. Mostly, the
cycle is peculiar to all companies within that industry. When business conditions are good, the company's
earnings rise and so does the stock price. However, when economic conditions deteriorate, profits take a
hit. Since they also suffer from the lack of product differentiation, the aggregate business activity has a
high influence on the company's sales and profit growth. However, investors stand to profit extensively if
they catch a cyclical company just ahead of a turn in the business cycle and exit before the cycle reverses.
IPCL in petrochemicals and ACC in the cement industry are good examples of cyclical companies.

Defensive:

These shares are stable and relatively safe in an economic downturn. They comprise companies whose
products are necessary in any economic climate, and hence are relatively shielded during economic
contractions. Stocks, which have this characteristic, are food companies (Nestle), drug companies (Cipla)
and utilities (BSES). Investors can also expect such companies to have relatively low business risk and not
excessive financial risk.

Growth:

Simply put, they are stocks with a relatively strong potential for sales and earnings. These are stocks,
which plough back most of their retained earnings into the business. If need be, they also tap the primary
market for funds more than just once. Investors don't even mind paying a premium for these stocks, as
long as their growth story is intact. They represent the ultimate in the stock market universe. The market
price of growth stocks can also be very volatile. They usually move up faster than other stocks, but can
come down sharply, if they miss the market's expectations (from quarter to quarter). But not all growth
stocks are growth companies. A growth stock can also be one, which will deliver a higher rate of return
(narrowly defined in terms of capital appreciation) than other stocks in the market with similar risk profiles.
Simply because, the market at some point in time undervalued its potential to other stocks. A handsome
profit awaits the investor, who can identify a stock, which can not only grow faster in terms of sales and
earnings, but also is relatively under valued in the market. Britannia between 1996-1999 and, Cadbury's
between 1997-1999 represented such opportunities.

Speculative:

It is a company whose asset involves great risk, but can also brings in big capital appreciation for its
investors. A perfect example is mining or an oil exploration company. But even otherwise, shares of
normally growing companies can turn speculative if they become takeover targets for the assets they own
(land, machinery, copyrights, brands and so on) or are expected to benefit from a huge contract (tender for
pipes used in deep-sea oil exploration).

Value:

It is used to describe stocks that are trading below their intrinsic value. Value investors typically like to
purchase stocks that are worth much more than what they paid for. Eventually, they believe, the market will
recognize the true value of the stock and run up the price. But the term 'value' can be misleading. One, if
intrinsic value is mistaken for replacement or liquidation value of a company. Two, accounting measures
such price-to-earnings or price-to-book, used to specify value in a stock trading at a discount to its peers,
lose relevance as they are based on historical numbers. And lastly, a stock which is trading at a discount
may actually be rightly traded so because of certain business fundamentals, which many investors may
have missed. Public sector companies, turnaround companies, companies in asset-based industries,
which normally trade at a discount to market, are often touted as value plays. Bear in mind that these
categories still could mean different things to different people. With just a little bit of looking, it's also easy
to find mutual funds that take one, the other, or a combined strategy. But as the saying goes, beauty lies in
the eye of the beholder. And as investors, it is up to you to decide which are the stocks/funds that suit your
risk profile.