Billionaire Carl Icahn: Investment Strategy, Philosophy, Quotes & More

If you’ve been involved in the stock market for quite some time, you must have heard of Carl Icahn. He is a famous American investor and founder and controlling shareholder of Icahn Enterprises. In case you haven’t, don’t worry. In this article, we shall discuss his investing philosophy. So, if you are a newbie in the world of investing, you are surely going to learn something new and informative today.

Apart from being a seasoned investor, Carl Icahn is also an established businessman and a philanthropist. He is the Chairman of Federal-Mogul which is an American developer, supplier, and manufacturer of vehicle safety products and power train components.

During the year 2017, Icahn provided his service to the present US President Donald Trump as a special economic adviser on financial regulation.

He founded his famous Asset Management Company in 1987 named Icahn Enterprises L.P. It is a conglomerate, headquartered at New York, USA. He is having the ultimate controlling power of his company where he owns a 95% stake in the same. The company has invested in diverse industries which include energy, auto parts, metals, casinos, rail cars, real estate, food packaging, and home fashion.

Carl Icahn Investing Philosophy

Let us now understand the investment philosophy of Carl Icahn

As per Mr. Icahn, he is a contrarian investor. He said, “My investment philosophy, generally, with exceptions, is to buy something when no one wants it.”

Carl Icahn looks to invest in those companies with share prices reflecting poor price-to-earnings (P/E) ratios. He hunts for those corporations with stocks having book values exceeding their current market values.

After that, he aggressively invests in the significant portion of equities of those corporations. Consequently, he becomes the largest shareholder of those companies.

Eventually, he calls general meetings to hold elections to form a new Board of Directors or passing the resolution for initiating divestiture of assets to deliver greater value to the shareholders.

Icahn focuses highly on the managerial remuneration. He believes that many top managerial people are highly overpaid and their compensation has little correlation with the equity performance.

You can study Carl Icahn’s portfolio here. From the portfolio of Icahn, we can learn three things about his investing approach.

1. Carl Icahn is more into trading than investing:

An analysis of his portfolio reveals that most of his stocks were bought in the last two years. It is his habit of not keeping stocks in his portfolio for more than one and a half years.

When he invests in a company, he invests to the extent that he becomes the largest stakeholder of the same. So, he gets the authority to call general meetings. He pressurizes such company for using cash or raising a loan to buyback stocks. This results in increasing the stock price in the short run.

Icahn is more concerned with making short term profits and little does he care for the long term viability of the company.

2. He invests in securities with high conviction:

When Icahn invests in a stock, it is highly likely that he has a strong conviction behind the investment. He invests in the equity of a company where he has a gut feeling to earn huge returns.

Icahn purchases stocks of those companies which are poorly managed and not performing profitably. He invests in such companies with the intention to force changes to occur in their operations and management.

He even makes the companies declare big dividend payout to the shareholders if he thinks it will lead to his increase in returns in the long run.

3. Icahn is an activist investor:

He is a frequent stock trader. He majorly invests in equities of the companies with the objective of making changes in those companies. It is an effort he makes to push the price of the stocks.

The management of a company can easily ignore an activist holding a small number of shares in the same. But, if a billionaire investor holds a high percentage of the company, he/she can’t be easily ignored by the company.

Icahn’s investing strategy is simply beyond the reach of individual retail investors. Every investor, whether big or small, should not blindly follow any investor to take any position in a company. But, still, Icahn’s quarterly filing of shareholdings to SEC is certainly worth paying a glance for a few minutes.

Also read: Howard Marks’ Investing Strategies & Lessons

Famous Quotes By Charle Ichan

— Charles Icahn on his investment strategy:

“I look at companies as businesses, while Wall Street analysts look for quarterly earnings performance. I buy assets and potential productivity. Wall Street buys earnings, so they miss a lot of things that I see in certain situations.”

— This is what Icahn has to say on takeovers:

“In takeovers, the metaphor is war. The secret is reserves. You must have reserves stretched way out ahead. You have to know that you could buy the company and not be stretched.”

— Charles Icahn thoughts on ethics:

“I’m happy stockholders benefited. But I’m no Robin Hood. I enjoy making money.”

— Finally, two other remarkable quotes of Charles Icahn:

“I make money. Nothing wrong with that. That’s what I want to do. That’s what I’m here to do. And that’s what I enjoy.”

“CEOs are paid for doing a terrible job. If the system wasn’t so messed up, guys like me wouldn’t make this kind of money.”

quote-some-people-get-rich-studying-artificial-intelligence-me-i-make-money-studying-natural-carl-icahn-87-46-10-min

(Image Credits: Azquotes)

Also read: 31 Hand-Picked Best Quotes on Investing: Buffett, Munger, Graham & More.

Closing Thoughts

In order to be a successful financial investor, an individual needs to be a finance enthusiast first of all. Secondly, he/she needs to study financial markets from various books and also follow the macroeconomic events and global stock markets. Lastly, it is important to study the investment approaches of renowned investors to understand their investing psychology.

Financial Market practitioners majorly advocate value investing to be a successful investor. Of course, it is one of the most successful ways to make wealth but there exist other methods to make money as well.

Carl Icahn is a different type of a stock market investor as compared to the old school value investors like Benjamin Graham and Warren Buffet. Unlike these two gentlemen, Mr. Icahn is more into trading than investing. Carl Icahn also focuses on Corporate Governance of the company whose share he buys. His philosophy is more based on short term profiteering rather than long term value investing.

He is an investor who has let us taste a different flavor of investing. There is no doubt in saying that one can definitely learn a lot as a fresher from the veteran investor.

7 Things to do Before You Start Investing

So, you’re thinking to start investing. But before you enter, are you prepared? Do you actually meet all the requirements that will make your investment journey smoother? In this post, we’ll discuss seven such things that you should do before you start investing.

1. Build an Emergency Fund

As the name suggests, an emergency fund is money that you put aside for emergencies. It is the money that you can reach out to during your hour of need and pay for those unforeseen and unexpected expenses such loss of a primary job, medical emergency, personal emergencies or even a car breakdown.

As a thumb rule, before you start making investments for your long-term goals, first you should build an emergency fund which should be greater than at least three times your monthly expenses. Keep this money aside in a separate account. You can read more about how to build an emergency fund here.

2. Have a budget & know your cash-flows

If you want to enjoy a healthy financial life, it’s really important to have a balance between your savings and your expenses. Budgeting your monthly finances and knowing your ‘cash’ inflow and outflow can help you plan how much you can afford to invest per month.

A simple profit and loss formula that you can use in your day-to-day life to understand your cash position is ‘Revenue — Expenses = Profit”.

Here, your total revenue (inflow) is the sum of all the income that you make from different sources like your job, business, interests on savings/fixed deposits, dividends, rental income, etc. And your total expenses (outflow) include your rent, groceries, transportation, bills, EMI’s, household expenses, etc.

When you deduct the total expenses from your net revenue, you’ll be able to find out how much you keep per month or year. And after calculating this, you can plan where to allocate this money and how much to invest in different investment options.

Note: If you are struggling with your personal budgeting, one of the easiest strategies that you can use to figure out how much should you save is the 50/20/30 Strategy.

50/20/30 is a really simple and straightforward budgeting strategy that can help you to define how much should you spend on your essential spendings (needs), savings and finally on your preferences (wants and choices). According to 50/20/30 strategy, you should allocate:

  • 50% of your monthly income on ‘Needs’ (like rent, food, etc)
  • 20% of your monthly income on ‘Savings’ (like your retirement fund, investments, etc)
  • And the remaining 30% of your monthly income on your ‘Wants’ (like traveling, dining out, etc)

50-30-20 rule

You can read more about the 50/20/30 budgeting strategy here.

3. Pay down high-interest debt

First of all, please note that not all loans or debts are bad. Here, we are talking about high-interest debts. For example, if you have taken a personal loan, it’s interest rate may vary from 13–18%. Similarly, a credit card company may charge you even higher interest on the outstanding amounts.

It doesn’t make much sense to invest if the profits that you make on your investments are lesser than the interests that you pay on your debts. For example, if your returns are 12% and you’re paying 14% as interest on your previous debt, then overall you’re in a loss. Here, instead of investing, it will be better to use that money to pay back and become debt-free.

Before you start investing, try to minimize or eliminate debt, especially high-interest debts and your credit card debt. These interests can kill your investment profits.

4. Take a health Insurance

When people are in the best of their physical health, an obvious question among them is why should they invest in health insurance? Paying a premium plan for ensuring health may seem an unnecessary expenditure.

However, accidents or health issues may come up anytime unexpectedly which can put a lot of financial and mental pressure. Further, it is a fact that, as you grow older, health issues come along with it. And hence, it is highly necessary to incorporate healthcare planning within the budget of your family financial planning.

Before you start investing, make sure to take health insurance first. Being medically insured can help you avoid facing financial instability in the future and enables you to get the best health treatment.

Also read: 6 Reasons Why You Should Get Health Insurance

5. Define your goals and make plans

One of the most critical things to do before you start investing is to define your investment goals/priorities and making plans to reach them. Here, you need to know why you are investing. It will keep you motivated and ‘on-track’ to achieve your goals.

Now, by definition, an investment goal is a realistic expectation to meet the returns by investing predefined money for a fixed time frame. The keywords to note here are ‘realistic expectations’ and ‘timeframe’.

Before you put your money in any investment options, set your short-term and long term goals and make plans for how you’re gonna achieve them. The goal can be person-specific like planning for children education, retirement fund, buying a new house or even financial independence. Once you’ve set your goal, you can choose the best investment options that can help you reach these goals in your defined time horizon.

Also read:How to Invest in Share Market? A Beginner’s guide

trade smart online discount broker 2

6. Evaluate your risk tolerance profile

Everyone has a different risk tolerance level depending on their age, financial situation, priorities, etc.

If you are young and have a stable job, you might be willing to invest in more unusual ‘high risk, high return’ options. However, as you grow old/retire, you might not have a job or primary source of income and hence you might depend on your retirement fund for meeting your expenses. Here, you may not be willing to take a higher risk and choose safer investment options.

Before investing, you need to define your risk sensitivity i.e. whether you’ve are high, moderate or low-risk tolerance profile.

As different investment options have different degree of risks, you can choose your investment options depending on your profile. For example, if you have a high-risk tolerance, you may invest in stocks, mutual funds, real estate, etc. On the other hand, if risky investments keep you sleepless at nights, better to choose low-risk investment options like fixed deposits, PPF, bonds, etc.

Also read:

7. Understand the investing basics

Don’t dive in deep water if you don’t know swimming basics. Similarly, do not start investing your money, if you do not understand the elementary concepts.

Before starting your investment journey, make sure that you understand what is meant by stocks, bonds, mutual funds, diversification, liquidity, volatility, and other investing basics. Here, you do not need to become a finance geek or an accountant. However, you should have good enough knowledge of the industry to make intelligent decisions.

That’s all for this post. I hope it was useful for you. Besides, if you are ready to get an education, here’s an amazing course on stock market investing for beginners that you should check out. Happy Investing.

What are the Different Career Options in Indian Stock Market?

The equity market has opened a lot of career opportunities in recent years. This market is getting bigger day by day and the opportunities for employment in the Stock Market are growing every day. People from all background whether science, commerce or humanities, are showing more and more interests to pursue their career in Stock Market today.

At one hand, many people are opting to become a financial market participant and work independently. On the other, a significant number of Startups are establishing innovative ideas to create disruption in the Indian Securities Market.

In this post, we are going to discuss a few excellent share market career opportunities in India. Let’s get started.

Different Career Options in Indian Stock Market-

Stock Broker

As you might already know, if you want to trade or invest in the Stock Market, you must open a trading and Demat Account. These two accounts are offered by stockbrokers. So, given the largely growing investing population of India, you can easily guess how prospective the career as a Stock Broker could be.

For example, If we take of Mr. Nithin Kamath, the founder of Zerodha (discount broker), he started off his career as an Engineer and subsequently started taking interest in the Stock Market. Later, he found the financial market so fascinating that he switched his profession as an engineer to a Stock Broker. In the year 2018, Zerodha, his stockbroking company was awarded the best discount broker entity in India by NSE.

zerodha kamath

Further, in order to become a Stock Broker or open a stockbroking entity, you don’t require a strict eligibility criterion in terms of academics. Nonetheless, you need to clear NISM exams and get your license from the SEBI. Anyways, if you plan to be a Stock Broker, it is important to gain a practical understanding of the Market. So, it is better to work with a Securities Broker for at least 5 years to gain requisite experience if you are willing to start your own venture.

Next, if you want to get employed in a Stock Broking Firm, you will need to clear 12th standard at the minimum. Graduating in Accounting, Economics or Finance will help you start your career from a decent level. Qualifying Post Graduation is not necessary but it might help in fast promotion in the industry. In case you have qualified professional courses like CFA, CA or FRM, no doubt your career path would become really smooth.

(Note: You can read detailed information regarding making a career as a Stock Market Broker here.)

Financial or Investment Advisor

If you want to start your own consultancy business in the Financial Market, becoming a Financial Advisor or an Investment Advisor is a perspective option.

In recent years, AMFI has been trying hard to bring the income earners in our country to invest in the Mutual Fund industry through their campaign “Mutual fund Sahi hai!”. However, just AMFI is not big enough to educate and convince billions of people in our nation to invest their money in the financial market. As an Investment Advisor, you can reach a plethora of prospective clients.

Preparing customized financial plans, providing consultancy services on wealth management and educating people on financial products can assuredly help you to build a career and make good money in this industry.

To become a Registered Investment Advisor, you will require an education and certification criterion. If you have a graduate degree in Finance/commerce or at least 5 years of work experience with a financial company, you meet the educational criteria. Note that if you are an engineer with just a B.Tech degree, you do not meet the educational criteria by SEBI. Here, you need work experience in the finance field for at least 5 years or a post-graduate degree in finance.

Anyways, if you are a Post Graduate degree in finance, you won’t require any work experience to apply for your license from SEBI. Further, whether you are a Graduate or a Post Graduate, you mandatorily need to clear the NISM Investment Advisory Certification exam to apply for the SEBI registered Investment advisor. Once you meet all the educational and certification criteria, you can apply to SEBI and get your license. (Note: You can read this post to learn further on how to become an Investment advisor in India.)

Besides, completing CA, CFA or CFP will also help you get the required knowledge you need to render professional services to your clients.

Also read: What is SEBI? And What is its role in Financial Market?

investment advisor

Research Analyst

Apart from becoming an investment advisor, Equity Research Analyst is also a lucrative career option nowadays. Let us have a brief understanding of this.

Equity Research includes Buy-Side Research and Sell-Side Research. In the case of the former, the researcher work with a financial service organization which directly invests people’s money in the Stock Market. Here, you need to research the stocks to help the Fund Managers make decisions with respect to managing the available financial assets. In the case of Sell-Side Research, the researchers analyze equities and equity derivatives for the clients who are retail traders and investors.

If you want to start your own business as an independent Research Analyst, the eligibility criteria are similar to Investment Advisory option. Further, if you want to take a job as a Research Analyst, the top financial service entities in India look for candidates who are MBA graduates from Tier 1 institutes. Nonetheless, you can also make a career as a Research Analyst if you have completed CFA or CA. (Note: You can read further regarding Equity Research Analyst profession here.)

Portfolio Management Services (PMS)

If you are a Mutual Fund investor, you might know that your investments are managed by the experienced and skilled Portfolio Managers. The Wealth Management firms operating in India handle clients’ money via professionally qualified Fund Managers. Portfolio Management could be an extremely rewarding career if you are good with managing money and have a strong understanding of the Financial Market.

In order to enter this field, you will require professional qualifications like CA, CFA or MBA (Finance). Moreover, if you are a fresher, it is extremely hard to get into this field. Here, you may need experience of at least a decade of working in the Finance domain as you need to grasp the level of maturity of handling assets which amount in crores. Therefore, if you are considering to become a Portfolio Manager, you may first start working in the marketing and research for 5 to 10 years. (Note: Here is a blog that can answer your additional questions on the career as a Portfolio Manager)

Conclusion

In this article, we tried to cover different career options in Indian stock market. Parting advises- if you are planning to make a living from the Stock Market, you need to have an in-depth understanding of the financial world.

Although possessing academics and professional qualifications are necessary but having practical exposure to how the market exactly works is more important. Besides, whichever stock market career option you choose, having strong communication and analytical skills are always add-on advantages.

Excusing ‘No time to invest’ has become a National Problem!

It’s a known fact that the majority of the Indian population do not invest their money. Apart from little allocation in a few traditional investment options like gold, savings, fixed deposits or LICs, the involvement of Indians in the higher-rewarding investment opportunities like Stocks, mutual funds, ETFs is quite minimal. If we look into the equity market, hardly 2.5% of Indians are actively involved.

Now, according to the non-investing population, the two biggest reasons that stop them from investing are ‘lack of education’ and ‘lack of time’.

For the first part i.e. the lack of education, it might be a little fault of our education system, somewhat of the parents but mostly of the individuals. Investing is not a rocket-science that only people with high-IQ can pursue. Anyone can learn and start investing. People should not always blame others if they are not ready to learn. There are a lot of free resources available online and offline, which is enough to get adequate investing knowledge.

Anyways, the other common excuse that most people make for not investing is that they don’t have enough time to invest. “No time to research where to invest!”. A few may even argue that setting up a trading account and making investments takes a lot of time which prevents them from investing.

However, all these are just excuses. In this online era, setting up demat and trading account is very fast, paperless and hassle-free. In fact, you can set up your trading account with online brokers like Zerodha, within 10 minutes. The problem is that you never researched where to open your trading account or how to get started.

It all depends on your priority…

“It takes too long to invest” — This is just another myth among beginners. However, it does not take as much time as every newbie assumes and investing habit can be easily adjusted in your day to day life.

If you can make time to go to the gym everyday, dining out every other day, partying on weekends, or going on vacations every three months, then stop saying you don’t have time. As a matter of fact, if you are ready to spend 2–4 hours every week, it is good enough to start and monitor your investments.

Further, even if you have a very hectic routine, you can steal a few minutes here and there. Like while traveling in your cab/metro, during your lunchtime, or even while having your coffee. At these time, instead of scrolling on facebook, you can do your investment research using mobile apps, which are super easy, fast and provides with all the facilities that you need.

Moreover, even if you are not ready to put a lot of efforts or time, there are still many easier routes to start investing. For example– investing in mutual funds or investing through Robo-advisors. If you believe that you won’t even be able to spend 2–4 hours per week for your investments, then pick a fund and start a monthly SIP. All these investment options do not take a lot of time.

Having no time to invest in a lame excuse for non-investors. The thing is these people never prioritize investing. They always keep procrastinating to invest for later, arguing that they do not have enough income/savings. Here, people are not investing because of the lack of priority, not the lack of time!

priority no time

You are losing ‘Time’…

“Start investing early” — this is the best advice that anyone can give you.

When you begin investing early, time is in your favor and so is the power of compounding. You will be way ahead of your peers towards building your investment corpus if you start investing even just a few years prior to them.

When you are excusing not enough time to invest, you are losing time that could have been your biggest ally. Remember, time can help or hurt you.

Also read: Bunty and Babli: A financial story of how Bunty lost Rs 1,29,94,044!

Sometimes later becomes never…

Every week, I receive dozens of emails from people in their 50s or 60s who have never invested in the equity market and now planning to enter.

Now, by no means, I am saying that people in their 50s or 60s cannot invest. As a matter of fact, it’s never too late to get started. However, these people kept excusing ‘no time to invest’ during their adulthood, which later resulted in them not to invest at all.

If you are young, you have a great advantage. Instead of throwing it away by making a lame excuse, take the best out of it.

Besides, you do not need to have a high paying job or large savings to start investing. Even people with medium to low salary range can invest smartly to reach their goals. If you are not sure how much, then a monthly SIP of Rs 5,000 is good enough to begin. That doesn’t sound too much to invest, does it?

No one cares about your financial goals except you…

Your friends will encourage you to party harder. You relatives will emotionally charge you to buy a fancy car/house to impress them. Your neighbors will challenge you to live above your standards to match them. But no one will motivate you to save more or to invest more.

No one cares whether your net worth or total asset is growing overtime or not. Everyone is dealing with their own financials/hardships and they don’t have any time for you.

The only one who cares about your financial situation is yourself. If you do not take charge of your investments, no one else is going to do it for you. The only way to secure your future and have enough money in your bank account is by becoming proactive and responsible for your financials.

Closing Thoughts

Stop excusing that you do have spare time to invest, instead start acting. Everyone has the same 24 hours in a day. If you are not investing, it’s not because you don’t have time. It’s because you do not understand the importance of investing.

And five years from now, you’ll regret why didn’t you start investing early.

Finally, as a bonus, if you are ready to take your first steps in the world of investment, here’s a free guide that can help you to get started. Good luck!

Is First Mover a competitive advantage for a firm?

Zerodha was the first mover in the discount broking industry. Unlike the traditional brokers like Sharekhan, ICICI Direct, HDFC sec, etc. who charge large brokerages for their trading services, Zerodha offers a low brokerage charge. And as of 2019, Zerodha has outranked all these big players to become the biggest broking firm in India.

While reading this incredible success of Zerodha, one obvious question among people is whether being the first mover in the discount business model, the biggest reason for the Zerodha’s success? How big is the actual competitive advantage for the first movers? In this post, we are going to discuss the same.

Who are First Movers?

First movers are those companies who are the ‘first’ in line to offer their products or services in the market. They are the ones to innovate and develop a product/service which was not available previously in the market. Further, they do not face similar competition like the ones in the established markets.

In many cases, such companies can build great brand recognition and loyal customers for their products/services during the time gap, i.e. before the competitors enter.

An important point to note is that first-mover advantage is here referred only to those companies who are able to scale and make establish a big market, not the ones who just started the idea but didn’t make it large.

I mean, Amazon might not be the first company in the online bookselling industry. A lot of small businesses might be selling books or their products online before its establishment. However, Amazon was the one who was able to capture a significant market, make an impact and hence, can be considered as an actual first mover in this industry.

A few other examples of the first movers in their respective industry can be Kindle (ebook selling), eBay (online auction), Apple (iPhone & iPads), Uber (taxi booking & ride-sharing), etc.

In India, companies like Flipkart, Oyo, Olx, Ola etc. are the ‘Regional’ first movers. Although they copied the concept from their global rivals, however, being the first mover in the Indian subcontinent region gave them an advantage.

Advantages of First Movers:

Being the first mover, a company can enjoy a lot of benefits compared to the later entrants. Here are a few of the best advantages of first movers:

  • Brand recognition: First movers can create a strong impression which can help them build a passionate customer fan-base and create a big brand recognition even before any competitors enter.
  • Price & Benchmarking: The first movers enjoy the advantage of setting up their prices for the newly offered products/services and creating their own industry standards/benchmark.
  • Technological advantages: Being the first mover and having no competition allows a company to give sufficient time to build a perfect product and get a head start. Further, they can also file proprietary or patent rights to continue enjoying technological advantages.
  • Control of resources: First movers can control the resources by doing a strategic partnership (or exclusive agreements) with vendors, supplier; renting the best locations, hiring most talented employees in their industry, etc. The later entrants may face difficulty to find similar resources.
  • Switching cost: If the customer has to cost a lot of money, time, efforts, or resources to switch from one product to another, it is considered as the switching cost. First movers can enjoy the benefits of switching cost by launching their products earlier. Here, even if a better product/service is available, the customer may stick with the old company, if the switching cost is high.

Also read: SWOT Analysis for Stocks: A Simple Yet Effective Study Tool.

Disadvantages of First movers:

Although being a first-mover looks a lot advantageous for a firm, however, it has its downsides too. Here are a few cons of being a first mover.

  • In most cases, the later entrants or competitors can reverse-engineer, copy, or even improve upon the product/services offered by the first movers.
  • The first movers might take a lot of time to learn and innovate. On the other hand, the following entrants generally have a lower learning curve and can build the product faster.
  • The first movers might find it challenging to persuade people to try new product/services. However, later entrants can reduce this education cost.
  • The first movers can also face a lot of competition from the free riders. As the Imitation cost < Innovation cost, a lot of copy-cats can join the expanding industry to enjoy the upwards ride and reduce the profitability of the first movers.
  • The second movers or the competitors can avoid the failed steps made by the first movers and hence reduce their cost/expenses.

Is First mover a competitive advantage for a firm?

In the investing world, the competitive advantages are the ones which are sustainable for the long term, not for a few years.

Admittedly, being the first mover is advantageous and have a lot of perks. However, over time, the later entrants can destroy this advantage through reverse-engineering, workforce mobility, technical advancement, or even by merely copying the products/service offered by the first mover.

Also read: Pat Dorsey’s Four Moats for Picking Quality Companies

Closing Thoughts:

There’s one thing sure in this competitive world. First movers will not always be the only player in any industry. As they grow, a lot of new companies will enter that industry and try to eat their profits.

Further, a lot of big successful global giants were not the first movers. For example, Google was not the first search engine. It followed the model of Yahoo or Infoseek. Similarly, Facebook was a later entrant in the social media world after Friendster and Orkut. Even Starbucks or Cafe Coffee Day (CCD) is a copied business model of the famous local coffee chains. Still, these companies were able to dominate the market and establish a big brand and customer network.

Anyways, in a few cases, if the first movers can dominate a big market and establish a loyal customer base, they may retain a healthy growth level and profitability, despite new entrants.

Should you invest in multiple Equity Linked Saving Schemes (ELSS)?

Equity Linked Saving Schemes or ELSS Fund is a variety of Equity Mutual Fund where the majority of the corpus is invested in equities and equity-oriented instruments. It is a tax saving Mutual Fund where your investments are locked in for 3 years.

ELSS are multi-cap equity funds which invest at least 4/5th of their assets in equities. Such stocks could be small-caps, large-caps, or mid-caps. ELSS funds can invest in the companies of any sizes. Apart from investing in the stocks of private companies, these funds also invest in the Government undertakings to a significant extent.

Note: If you are new to ELSS, you can read our previously published article here.

ELSS: A tax saving instrument

Previously people used to find FD, NPS, PPF, and ULIP as effective tax saving schemes. Nowadays, the taxpayers are feeling more interested in investing their savings in ELSS funds for availing tax benefit.

ELSS is not only having the lowest lock-in period but it also yields higher returns than the other conventional tax-saving instruments. If you are going to redeem your ELSS investments after 3 years, your capital gain will be taxed @ 10% if it crosses Rs 1 lakh.

As per section 80C of the Income Tax Act, 1961, you can get the benefit of tax deduction in a financial year up to Rs 1.5 lakhs. ELSS or Equity Linked Saving Scheme is a prescribed instrument under the said section. So, you can easily save your tax liability up to Rs 46, 800 (Tax plus Cess on such Tax).

Investing in ELSS for generating long-term wealth

If you are looking to create long-term wealth but willing to accept the risk, let me tell you that equities or equity-oriented funds are the best for you. Equities can fetch you substantial returns if you are willing to stay invested for the long term.

You can choose any form of Mutual Fund i.e. a small-cap fund, large-cap fund or a mid-cap fund. But, neither of the funds can provide you with tax benefits which ELSS can give. Moreover, if the markets seem to be bearish or moving sideways in the short run, you might feel like redeeming your units immediately.

If you have invested in ELSS, you can’t withdraw your investments before the expiry of three years. In that way, investing in ELSS ensures that you stay invested for a long-term irrespective of short-term volatility. So, if you are interested in staying invested for a considerably long period of time, ELSS is definitely an ideal investment option for you.

Should you go for only one ELSS or multiple?

In an ELSS fund, the underlying portfolio consists of around 70 to 100 stocks. Around 5,000 stocks are listed in the Indian markets. Out of such stocks, the top 250 of them contributes towards 90% of the total market capitalization. So, if you are investing in 6 ELSS funds, it means you are indirectly investing in around 600 stocks. This implies that you will end up investing in the stock market as a whole. Therefore, you are virtually removing all possibilities to beat the stock market.

Investing in excessive ELSS funds means you are indirectly looking to form a market portfolio. So, if you are looking to earn what a market index earns, you can opt for such a portfolio. It is highly probable that you won’t earn more than what the market earns but you are also not going to earn less than the same.

There is another limitation of investing in too many ELSS funds. Investing in an excessive number of ELSS will lead to portfolio overlapping. It means that you will be investing in the same stocks through multiple schemes. This would unnecessarily increase your expense ratio instead of yielding the benefit of diversification.

Well, if you are simply looking to invest in the market portfolio, you should consider investing in an Index Mutual Fund or an Index ETF. Through the passive funds, you will be investing in the market indices at a lower cost.

Let us discuss how the situation might look like if your portfolio consists of a single ELSS. If you own only one ELSS fund, it indicates that you have not diversified your investments at all. It seems to be a risky portfolio as you will be exposing it to the risk of underperformance of the Fund Manager. It is of no doubt that you have a higher chance of beating the market if the underlying assets of your scheme consist of top-performing stocks. But, if the market witnesses a downfall, your portfolio will crash down at a higher rate.

An ideal number of ELSS funds for your portfolio

Now, if you ask how many ELSS funds you should have in your portfolio, the ideal number could be either two or three. An ELSS fund is a multi-cap equity fund. Therefore, if you have chosen two to three ELSS funds in your portfolio, you can certainly form a strong portfolio in all possible ways.

Through a single ELSS fund, it is not possible for you to cover a substantial number of top equities. The likeliness increases if you add one or two more ELSS funds in your armory. If your investments can be spread across a good number of profitable stocks, you are going to make significant returns in the days to come. Although your portfolio expenses in the form of equity ratio will go up, the returns are high enough to cover the same comfortably.

We have discussed earlier that too many funds would lead to portfolio overlapping. But, you would not experience the same if you create your portfolio with two to three funds. Investment in a limited number of schemes is not going to capture the major portion of market capitalization. Therefore, you are not forming a portfolio which can replicate the market. So, whatever you will be earning will supposedly beat the market.

Also read:

Closing thoughts

No assurance can be given whether a portfolio consisting of two to three ELSS funds can alone serve all your wealth generation and tax-saving requirements. Forming a portfolio for an individual is dependent on several factors. If you are an investor with a high-risk appetite you can team up a small-cap equity fund with a ULIP. On the other hand, if you are highly risk-averse, you can go for a debt fund with a PPF.

Through this article, we have tried to give you a general idea regarding the number of ELSS funds which should be there in your portfolio. If you are seeking an investment option which combines wealth creation and tax saving, ELSS is your answer. Otherwise, if you have any specific requirements with respect to profitability, liquidity, and tax benefit, you are free to create your own portfolio accordingly.

15 Must Know Tax Saving Tips in India

If you are an Indian resident, you are required to pay tax on your income (if it crosses the minimum taxable limit) to the Indian Government. Do you ever feel like you are paying an excessive tax? Have you ever thought of saving some tax from your taxable income?

The Income Tax Act, 1961 is a complicated statute in itself. If you are looking to carry out your personal tax planning, you might it find it a real tough job to accomplish.

In this article, we shall talk about the various ways which you can adopt to save your taxes.

15 Must-Know Tax Saving Tips in India

Let us first talk about the tax deductions you can claim by investing in some financial instruments specified u/s 80C. The maximum tax benefit allowed under this section is Rs 1.5 lakh.

1. Public Provident Fund

Investment in PPF (Public Provident Fund) is subjected to EEE tax exemption status. It is a savings scheme established by the Government which comes with a maturity period of 15 years. You can invest in it by visiting any bank or post office in India. Currently, the rate of interest offered on PPF is 8% every year.

2. Employees’ Provident Fund

If you are a salaried individual, you can claim a tax deduction on the contributions you make in your EPF account. The maturity amount and the interest income on EPF have also been exempted from Income Tax provided you have completed 5 years of service.

3. Five-year tax-saver Fixed Deposits

You can invest in 5-year tax-saver FDs to claim a tax deduction in a Financial Year up to Rs 1.5 lakh. These instruments carry a fixed rate of interest varying from 7 to 8% p.a.

4. National Saving Certificate (NSC)

NSC is having a lock-in period of 5 years and offers interest at a fixed rate. At present, the interest rate is 8% p.a. You can get tax benefits on both investments made and interests received.

5. Equity Linked Saving Schemes (ELSS)

ELSS funds invest a minimum of 4/5th of their assets in Equities. They have a lock-in period of 3 years. If your long term capital gain exceeds Rs 1 lakh during redemption, then such gains are subjected to tax @10%.

6. Life Insurance Policies

You can claim a tax deduction for the premiums you pay for various types of life insurance policies which include endowment plan, term plan, and ULIP. But, for availing this tax benefit, the sum assured (insurance cover) must be a minimum of 10 times the amount of premium which you pay.

7. Interests on home loans

When you repay your home loan (procured for acquiring or constructing a house), the principal portion of the same is deductible under Income Tax. The interests that you pay are eligible for tax deduction u/s 24(b) of the said Act while computing income from house property.

8. Senior Citizen Saving Schemes (SCSS)

The contributions made to an SCSS are eligible for a tax deduction. SCSS is having a tenure of 5 years. It is available for investments for those who are above 60 years. The rate of return offered by an SCSS is currently 8.7% per annum which is higher than a bank FD.

(Image credits: Paisabazaar)

Apart from section 80C, there are various other sections in the Income Tax Act of India which provides you with tax benefits.

9. National Pension Scheme (NPS)

Whatever contribution you make in your NPS account, you are eligible to obtain tax benefit up to Rs 1.5 lakh under section 80C. An additional tax deduction to the maximum of Rs 50k u/s 80CCD(1B) is available on your contributions in your NPS account. Investing in NPS lets you invest in both equities and debts at the same time and build a significant retirement corpus.

Also read:

10. Medical Insurance Premiums

You can avail tax deduction up to Rs 25k on medical insurance premiums paid u/s 80D. This tax benefit is allowed to you and your family. For senior citizens, this limit changes to Rs 50k. Again, if you are paying health insurance premiums for yourself and/or your family and senior citizen parents, the maximum combined deduction available is Rs 75k in a Financial Year.

11. House Rent Allowance (HRA)

If you are a salaried employee getting House Rent Allowance (HRA), you can enjoy tax exemption on the same if you stay in a rented house. But, if you don’t get HRA from your job but staying in rented accommodation, you can still claim tax deduction u/s 80GG to the maximum of Rs 60,000 p.a.

12. Home loan for constructing a house property

If you have raised a home loan for acquiring or constructing a house property, the interest payable on the same is tax deductible u/s 24 up to a limit of Rs 2 lakh per year. But, the interesting thing is that, instead of a self-occupied property, if you have given the house on rent, there is no upper limit for it. But, the total loss that you can claim on the head of income from house property is limited to Rs 2 lakh.

13. Partial benefits on Saving Account Interests

The interests that you receive on your Savings Bank Account are tax-free to a limit of Rs 10,000 per year u/s 80TTA. But, if you are a senior citizen, the tax deduction on interests received on both FD and savings account is allowed up to Rs 50,000 u/s 80TTB.

15. Disabled Assessee Deductions

If you are an Assessee suffering from any disability, you can claim tax deduction u/s 80U for yourself. Under this section, the maximum deduction from your taxable income allowed is Rs 1, 25,000.

15. Disabled dependent deductions

You can enjoy tax benefit u/s 80DD if there is any disabled person in your family who is dependent on you for his/her living. This section allows you to claim a deduction of Rs 1.25 lakhs from your taxable income.

Bonus: Donation or relief funds

If you make a donation to any relief fund or charitable institution, the limit of the tax deduction is 50% of your donated amount. Some entities allow 100% tax benefits on the donations made, subject to a maximum of 10% of the adjusted total income. There are some organizations where 100% of your donations are allowed as tax deductions without any conditions.

Closing Thoughts

In this article, we have provided you with some tax-saving tips. If you could follow our guidance, it would help you to plan your personal taxes better. The Income Tax Law of India is itself a huge one. Further, many amendments come every year in the form of a new budget (Finance Act), circulars, notifications, and case laws.

Therefore, we would like to warn you that you should not rely only on our stated tax-saving strategies. For managing your tax compliances in the most effective manner, it is recommended that you consult any tax consultant like a Lawyer or a practicing Chartered Accountant.

We wish you all the best for your personal tax planning.

What is Sustainable Growth Rate (SGR)?

While investing in a company, one of the most critical factors to look at is its growth rate. At what percentage the company is estimated to grow in the upcoming years? This is because, as the company grows & generate more profits, generally, your investment will grow along with it. Moreover, it’s not a viable strategy to invest in declining companies or the ones with no significant growth aspects.

But how to calculate the growth rate of a company?

A common approach that most investors follow is to look into the historical growth rate. Here, they try to find out the rate at which revenue, earnings, etc are historically growing, to assume a similar growth rate in the future. Although past performance doesn’t guarantee future growth, however, it can give you a rough estimation if you expect the company to perform similarly in the future. Here, investors can use the compounded annual growth rate approach to define growth.

However, forecasting growth based on such estimations may not always be valid. Besides, the estimates can change depending on the ‘number of years’ that you’re considering. For example, past 3-years, 5-years, and 10-years historical growth rate might be totally different. Which one should the investors focus while forecasting the future?

A better approach while studying growth is to look into the sustainable growth rate (SGR) of a company which focuses on different factors like earnings, shareholder’s equity, payout etc to find out the growth percentage of a company. But what exactly is a sustainable growth rate? This is what we are going to discuss in this post.

Sustainable Growth Rate (SGR)

The sustainable growth rate is the maximum growth rate that a company can sustain using its own resources i.e. without financing the growth using debt or equity dilution. It is calculated as:

Sustainable Growth Rate (SGR) = ROE * Retention Rate (RR)

Where,

  • Return on Equity(ROE): ROE is the amount of net income returned as a percentage of shareholders equity. It can be calculated as: ROE= (Net income/ average stockholder equity). ROE shows how good is the company in rewarding its shareholders. A higher ROE means that the company generates a higher profit from the money that the shareholders have invested.
  • Retention Rate (RR): This is the percentage of net income that is retained to grow the business, rather than being paid out as dividends. Retention rate is calculated as: RR= (1 — Payout ratio) = ( 1 — DPS/EPS), where DPS is the dividend per share and EPS is earnings per share.

For example, if a company ABC has a ROE of 15% and payout ratio of 40%, then its sustainable growth growth rate can be calculated as: SGR = 15 * ( 1–0.4) = 15 * 0.6 = 9%.

Also read: 19 Most Important Financial Ratios for Investors

Ideally, the growth of a company funded by its own resources is the best form of growth compared to any other leveraged growth options. The later scenario may lead to financial stress and in the worst case, bankruptcy.

Moreover, any company can grow at a faster if it takes a lot of debt and spends on marketing, new product development, acquisitions, etc. However, returning that debt can be a troublesome process if it’s business model is not that strong.

By looking into the SGR of a company, Investors can find out its long-term growth, current life cycle stage, cash flow projections, borrowing & dividend allocation strategies, etc.

Maximum SGR:

According to the sustainable growth rate formula, SGR = ROE * RR = ROE* (1  –  Payout Ratio)

Here, when the payout ratio is zero, the SGR becomes equal to the ROE of the company. You can maximize the sustainable growth rate by increasing ROE or decreasing payout (i.e. retaining more earnings rather than paying out as dividends).

Note: You can also analyze the root cause of ROE further using the DuPont Analysis.

Technically, a few ways to maximize SGR is by increasing sales & profit margin, managing account payable & receivables, efficient inventory management, etc. However, a point to note here is that a high SGR is always difficult to maintain. As the company matures, it cannot sustain similar high past growth rates.

Closing Thoughts:

An efficient management’s goal is to grow the company at its sustainable growth rate.  If the SGR is 15%, the company can safely grow at this percentage per annum without taking any additional financial leverage. It can be considered the ceiling growth rate of a company while using its own resources.

How to learn faster- The Feynman Technique!

As the world around us evolves, we seek to constantly learn and absorb new information every day. Learning new skills and concepts is exciting and can expand your views on the world as you know it, making you a better student and human being. As Benjamin Franklin said ‘An investment in knowledge pays the best interest’.

But there is no denying that learning all this new information can sometimes get tedious and monotonous, there’s only so much knowledge that your mind can take in at any given time. However, thanks to scientific research, there is a method you can use to make the process of studying easier and efficient while increasing your ability to learn- the Feynman Technique. But before we discuss this technique, let me first introduce Richard Feynman to you.

Who was Richard Feynman?

richard feynmanTheoretical physicist and Noble laureate Richard Feynman was born in 1918 in Queens, New York. From a very young age, Feynman quickly took to science and engineering and had a laboratory in his parent’s home where he built various electronic devices.

By a young age, he was self-taught in various subjects such as algebra, trigonometry, and integrals. Eventually, Feynman went on to study at MIT and later Princeton for his Ph.d, where he made numerous contributions in the field of Physics. Some of his accomplishments include:

  • He contributed research papers on the theory of light and matter which earned him a joint Noble Prize in 1965.
  • When the Space Shuttle Challenger disaster occurred, Feynman helped research scientists understand the cause for the crash and the risks involved in flying the shuttle
  • He made a major contribution to quantum physics through the Feynman Diagram. The diagram aimed to visualize the interactions between elementary particles such as electrons and photons.

In addition to the major contributions to Physics, Feynman had the ability to apply his learnings to other fields such as mathematics and biology. He has the ability to comprehend and explain information on a variety of subjects that earned him the title ‘The Great Explainer.’ His vast knowledge led him to give numerous guest lectures at universities such as Cal Tech and UCLA. Many people, including Bill Gates, enjoyed his lectures due to his ability to break down and simplify complex scientific principles.

The Feynman Technique

Say you want to have a good understanding of a really hard concept in a discipline of your choice. There’s a chance that you may find the theory hard to comprehend as the crux of the matter is lost in translation aka with all the business jargon. The ability to understand and communicate these complex ideas in a simple way is what the Feynman technique addresses.

This method was developed by Richard Feynman when he was a student at Princeton. He kept a notebook of concepts and theories that he did not understand and spent time breaking down each process and understanding its parts individually, while looking for contradictory details in the theory. The technique essentially comprises of four parts as follows:

1. Pick the concept or theory you wish to learn

The first step in the Feynman technique is to identify what concept or theory you want to learn and list out everything that you know about the topic in a notebook. This could be any concept, under any discipline.

For instance, if you want to learn more about the game theory, your first step would be to write down all the existing (even limited) information that you have on the topic. Any new information about the theory from various other sources can be added to the notebook. For the game theory, you can start by writing down the definition of the concept and any information about the theory that you may have come across (for example prisoner’s dilemma…).

2. Teach or explain the concept in your own words to someone else

As you approach the second step in the Feynman technique, you would have gathered plenty of information on the subject (in this case game theory). Read through the information you have written down and try to understand the concept as best you can because this step involves teaching it to someone else.

But before you explain the concept, analyze the information in parts, this can also mean re-writing some of the information in your own words to have a better understanding. When explaining the concept, think of it as explaining to a child who has no background in what the concept is about. Hence, you need to use simple words (no jargon) and keep the information concise and to the point- children have a low attention span.

3. Identify any areas in your explanation that you can improve on

Now that you’ve explained the concept to someone else, it is likely that you will find a few areas in the theory that you can learn and improve on. So it’s back to the books to do additional research on certain concepts and breaking the data down further until you understand them completely. The goal is to make the information as simple as possible because that’s what the Feynman technique is all about.

4. Restructure the information and use examples as needed

The information you collected from various sources in the first step of the Feynman technique is essentially a puzzle that you need to solve.

Once you have identified the gaps in your information in step 3, your next move is to fill in these gaps to complete the puzzle. Think of your concept as a story and pretend that you are narrating it to a friend or co-worker.

When you say the information out loud, it can help identify the missing pieces and form new thought processes. Alternatively, you can use examples to simplify your learnings and add an element of creativity.

the feynman technique safal niveshak

(Image credits: Safal Niveshak)

Also read:

Conclusion

The Feynman technique aims to simplify complex learnings by breaking them down into smaller parts.

The technique can help you understand pretty much any concept or theory known to man and it helped Feynman amass large amounts of knowledge at a very young age. The trick is to break down any concept into a form so simple, that even a child would be able to comprehend the information. Albert Einstein famously said ‘if you can’t explain it simply, you don’t understand it well enough.’

NISM Certification – A Complete Beginner’s Guide

The majority of Commerce students that I come across these days are looking to make their career in the field of Finance. Even, a substantial number of engineering graduates whom I personally know, are currently changing their career to the Financial Services. At present, the Finance industry in India and across the globe is growing at a rapid pace. Therefore, it is of no doubt in saying that professional degrees and courses like MBA (Finance), CFA, FRM, and CFP are attracting a huge number of students every day.

However, apart from these mentioned courses, is there any other course which can give you the license to work as a self-employed individual in the Finance sector? Do you know of any course which is comparatively easier to pursue, affordable and gives you the ticket to pursue a career in the Finance industry?

The answer to both the questions is “NISM certification”.

But hey! Are you hearing the word ‘NISM’ for the first time? Even if yes, then you don’t need to worry at all. In this article, I would share a brief overview of the wide range of NISM courses available and how you can get certified with NISM.

What is NISM?

nism certification

NISM (National Institute of Securities Markets) is headquartered in Navi Mumbai, India and offers a wide range of courses to the Indian students. It is a public trust which was established by SEBI (Securities and Exchange Board of India). SEBI is the apex body which regulates the securities markets in India.

The SCI (School for Certification of Intermediaries) is one of the six schools of excellence at NISM. The SCI is engaged in the development of Certification examinations and Continuing Professional Education (CPE) programmes in the Financial Markets domain. These are conducted for validating and enhancing the abilities of the associates working in the Indian capital markets.

What does the NISM offer?

The NISM campus in Patalganga (Maharashtra) offers two full-time courses in Finance. The first one is PGPSM (Post Graduate Programme in Securities Markets) and the other is PGD (Post Graduate Diploma) in FinTech.

Apart from these two stated courses, NISM also offers a few other long term courses in collaboration with international bodies. You can have a look at those courses clicking here.

Further, there are 22 short term certification courses offered by NISM. In this article, we would predominantly hold a discussion on these certifications. A majority of these short term courses are mandated by SEBI for those who are either self-employed like an investment advisor or research analyst or working in the Financial Services industry in India.

The rests are voluntary certifications which have not been mandatory for the finance professionals. But, the voluntary certifications are beneficial in the sense that they provide advanced knowledge in some specific area.

For example, Mutual Fund Distributors Certification Examination (Series V C) is a voluntary exam but its contents and way of testing the candidates is more difficult than other Mutual Funds exams.

nism courses

Note: You can find the list of all the available 22 courses on the website of NISM here.

How to register for a NISM certification exam?

In order to register for any course offered by NISM, you first need to create your account on the NISM website. Click on this link and it will take you to the home page of the website. While creating your account, make sure you have a digital copy of your photograph, aadhar card and PAN card with you.

After you are done with the account creation, you can choose any module of your choice. To register for any module exam, you have to select the exam date, time and center first. After that, it will take you to the payment gateway.

Once you have paid the required exam fees, you would get the soft copy of the workbook (study material) and the hall ticket in your account. Take a physical printout of your hall ticket and carry it with you to the exam center on the day of your exam.

Also read: Want to Take NSE Certification Exam? Now You Can!

How are the contents of NISM courses?

The NISM provides the students with soft copies of the study materials in the ‘pdf’ format. The content covers both theoretical and practical aspects of the Financial Markets. These courses teach you various jargons which you need to know for pursuing a career in the Financial Markets.

Anyways, you can also enroll in these courses if you are simply interested in gaining knowledge. These programmes teach you the key theoretical concepts of the Stock Market, Mutual Fund, Financial Planning, and many others. The exams are based on MCQ (Multiple Choice Questions) and the students are tested on their conceptual understanding.  Although you don’t get the opportunity to work on demo projects here, you certainly get the chance to solve case study questions in the exams. Further, you cannot carry a scientific calculator in the exam. But, you are definitely allowed to do rough works in MS Excel, OpenOffice or digital calc on the given desktop in the exam hall.

The NISM certification exams majorly focus on the practical understanding rather than emphasizing on mugging up theories. The best feature of these certifications is that the course modules are updated in every year.

How much time does it take for the completion of a NISM course?

In case of a NISM certification examination, you don’t need any significant amount of time to complete the same unlike CA, CFA, or MBA (Finance). Practically speaking, you can book your exam slot at any time. However, it is recommended that you should prepare for at least two weeks to a month before taking any module exam. This is because when you register for an exam, you get the study material covering a minimum of 100 pages which needs a decent time for complete reading.

If you are only looking to clear the exam, you can do the same by referring to the mock tests of private institutions. But, if you are looking to gain knowledge of the financial markets and clear the exams with distinction marks, you must study the workbooks given to you by NISM.

What is the registration fee to be paid to opt for a NISM certification exam?

The registration fee for any exam is pretty reasonable in nature. Here, you don’t need to pay over 30 or 40 thousand rupees to write a semester of MBA or a level exam in CFA.

Today, you can register in a NISM exam for as low as Rs 1200. The module exam with the highest registration fee is Rs 3000. Whenever you are enrolling for an exam of NISM, you have to pay the required fees. If you are unable to attempt that exam or fail in the same, you have to pay the same fee again for re-appearing in the exam.

How’s the difficulty level of a NISM exam?

The difficulty level of the NISM exams is between average to moderately high. For some exams, the contents and way of testing could be more difficult than the rests. The NISM Investment Advisor Exams (Level 1 and 2) contain relatively more practical contents as compared to the other courses. On the other hand, exams like the NISM (Series VI) Depository Operations Certification Examination contain a very high share of theory portion in their syllabus.

In order to pass a module, you need to secure a minimum of 60% score in most of the module exams. Besides, these exams come with negative marking of 25% per question. A very few exams like NISM (Series V A) Mutual Funds Distributors Certification Examination have a minimum passing marks criteria of 50% and also they don’t have any negative marking feature.

Conclusion

NISM exams are definitely one of the best in the industry if you are a fresher and willing to make a career in Finance. These certification exams are sufficient to give you an initial push in your career. They are strong enough to add a few keywords in your resume and make it look better than your peers. But, you must understand that clearing these exams are not going to make you stand at par with the jobseekers having CA, CFA, FRM or MBA (Finance) in their portfolio.

Nonetheless, in case you are looking for a job after graduation, these courses can help you in getting shortlisted on India’s top job websites. It is easy to start your career as a Mutual Fund Selling Agent or an Equity Dealer clearing the required NISM exams. But, if you are aiming for a career in Portfolio Management, Investment Banking or Fund Manager, you should look for the premier courses in Finance.

How Do Companies Cook The Books?

Financial statements are one of the widely relied upon tool to analyze a business. However, there are many ways in which companies cook their books and create a false impression of the company’s financial health using accounting gimmicks and financial shenanigans. In this post, we are going to look at how companies cook books and how you can identify such financial shenanigans using accounting red flags.

If you look into the past, you will find that cooking books is not a recent phenomenon, but has existed for a long time. We all know one or the other company which has resorted to accounting gimmicks to dupe investors into believing that the company is doing well. Each market has its own share of such “gutsy” companies which, instead of genuinely improving the business, resorts to cooking books to show improved performance.

Why Companies Cook Books?

How Do Companies Cook The Books cover

The question is, why do companies need to cook books? Why does the management resort to such gimmicks instead of being honest with their investors? Well, cooking books is not just about looking great on paper, some of the common reasons why companies do so are explained below:

1. To meet or exceed market expectations:

Let’s honestly admit one thing, the world is a fiercely competitive place and everyone wants to be on the top of their game. Miss the mark by a few points, and the company’s stock price gets hammered badly by the market.

With ever intensifying competition and “Go big or go home” thinking, the management of every company is pressed to either beat or at least meet the growth expected by the market.

With such mounting pressure to perform, companies that fail to deliver as per expectations, often get involved in cooking books and create a false image of healthy growth.

2. Vested Interests of the Management: 

The second reason why companies cook books is because the management has its own vested interest behind it. Nowadays, many companies offer share price linked incentives to their managers.

Such schemes are offered to align the interests of the shareholders to that of management so that both can benefit from the good performance of the business.

Incentives linked to the share price motivates the managers of the company to work harder and deliver a good performance.

When the times are tough, and business struggles to perform, top managers, driven by greed of incentives and fear of being penalized for poor performance start window dressing the accounts to paint a rosy picture of company’s performance.

3. To show a consistent growth rate by under-reporting current spurt of growth:

This is something that does not happen pretty often, but there are times when companies do under-report their financial performance. Why? Let me explain.

Investors love companies with strong consistent performance and growth, and company managers know this very well. There are some companies that have a seasonal business, where they perform well when times are favorable and do poorly otherwise.

Such companies during good times minimize the current earnings by under-reporting the revenues or by inflating current period expenses by postponing good financial information for the future period when the company is more likely to underperform.

This again creates an illusion for investors that the company has performed well compared to its peers even during tough times.

As a result, such companies command higher valuations which they do not actually deserve.

How Companies cook books?

Management of the companies may have different reasons behind cooking books, but the way it is achieved has hardly ever changed.

The only way management of the companies can manipulate books is by concealing information, in other words, by hiding it in places where it is difficult to detect easily.

So how do companies cook books? Well, as I said earlier, it’s all about hiding crucial information about the company within the financial statements so that they are not easily traceable.

There are only three ways a company can manipulate earnings, by manipulating earnings, profit, and cash flow.

1. Earnings Manipulation:

Earnings manipulation occurs when companies try to inflate (or in some cases, hide) their earnings such as revenue. There are two ways companies manipulate their earnings.

— Recording Revenue prematurely: Booking revenues in advance is one of the most commonly used financial shenanigan by the companies. It includes booking revenues even before the goods are sold or a project is completed.

An example of such premature recording of revenue was seen in Sobha Developers in 2008-09. In Q1 of 2008-09, Sobha Developers decided to recognize the revenue earlier during a project cycle. This led to a 20% jump in the company’s profits before tax.

— Recording income from investment as revenue: The second most common way to manipulating earnings is by recording revenue from other sources as operating revenue.

If proceeds from the sale of an asset (such as land, building, plant, and machinery) or income from an investment (such as maturity of a bond or proceeds from the sale of shares) is recorded as revenue, it will boost the total revenue of the company.

Since these are a one-time phenomenon, and cannot be repeated in the future, recording such one-time sources of revenue gives a false impression of improved financial performance.

earnings manipulation

2. Profit Manipulation:

Profit is considered to be the blood of a business, something which is necessary for the survival and prosperity of a business. Just like revenue, even profits can be manipulated in many ways.

From hiding expenses to making a simple change in the way in which depreciation is calculated, there are numerous ways a company can manipulate its profits numbers. Some of the most common ways companies cook books in terms of profit are as follows:

— Making expenses look like earnings: A simple change in accounting policy can have a significant impact on the way profits are presented. Many companies use this approach to manipulate Net Profits.

For example, a simple change in the way depreciation is calculated can change the entire picture, helping company management boost profits.

For Example, a small change in depreciation policy in case of Jet Airways created profits out of thin air. In the Q2 of 2008-09, Jet airways changed its depreciation policy from written down value method to straight-line value method, as a result of which, Jet Airways was able to write back ₹920 crores to its Profit and Loss account.

— Hiding Expenses as Capital Expenditure: Another way to boost profits is by treating expenses as capital expenditure; that is instead of treating it as expenses during the current financial year, it is treated as investment made to expand the business.

One such incident can be found in the USA, wherein the years 1990, AOL was found guilty of delaying expense.

AOL was distributing installation CDs as a part of its marketing campaign, but instead of treating it as an advertising expense, AOL decided to view it as capital expenditure. As a result of this, the entire amount was transferred from profit and loss statement to balance sheet of the company where the campaign would be expended over a period of years.

Because of AOL’s treatment of expenses as Capital Expenditure, the entire amount was written off the P&L Statement, which resulted in boosted profits.

3. Cash Flow Manipulation:

Cash flow is considered to be the most reliable source of the true financial health of the company for the simple reason that cash is difficult to manipulate. Investors like Warren Buffett rely heavily on numbers like free cash flow to assess the financial health of the business.

Since companies know this well, they have devised new ways where it is possible to manipulate the cash flow of a company using accounting gimmicks.

Detecting such tricks can be quiet challenging for an amateur investor who does not have a deep understanding of accounting and finance or does not have free time to go through the books of the company.

Some of the most common cash flow related financial shenanigans are explained below:

— Showing financing cash flow as operating cash flow: There are two ways a company can generate cash for itself, first, from its own business, where profits earned by the business get converted to cash, and second by borrowing cash from an external source in the form of loan by issuing bonds or bank loan.

The cash received from business operations is called Cash Flow from Operating Activity, and cash received from an external source is treated as cash flow from financing activity.   

Many companies try to boost their operating cash flow by treating financing cash flows as operating one, which leads to a wrongful impression that the company is generating a lot of operating cash flow from its business.

— Using acquisitions as a boost to operating cash flow:

Cash flows can also be manipulated using mergers and acquisitions, especially if the target company is rich in cash.

Management often tries to win support from its shareholders by convincing the shareholders that a particular acquisition will be highly beneficial for the company.

As soon as the merger takes place, all the cash that belonged to the target company, now becomes a part of the parent company, thus boosting overall cash flow statements.

Investors must always be wary of the financial history of the target company and its business and find out if the merger is really going to benefit the business.

If an acquisition is happening just because it will boost the EPS or the cash flows of the parent company, with no meaningful benefit to the business, then such acquisitions must be avoided at all costs.

Also read:

Some Additional ways companies cook books:

cook books by companies

Cooking books is not limited to manipulating earnings or hiding crucial details about the weak performance of the company, management of companies go beyond the books and create their own parameters of measuring the growth and performance of a company.

Such parameters, though necessary in certain industries, are still non-standard as per the accounting standards. Because of such creative parameters, managements get an opportunity to change their definition of performance as per their requirements, allowing them to use creative methods to put encouraging but false performance numbers in front of investors.

Some of the examples of such no-standard parameters are explained below:

— Same Store Sales (Used In Retail Stores and Restaurants):

Same store sales is a parameter to measure the performance of retail stores. It gives information about how much sales revenue a store is generating during a fiscal year or more.

Same store sales also give investors an idea of how much revenue a company is generating from its existing stores and how much is contributed by new stores. If the percentage of sales revenue from new store sales is rising, it’s strong evidence that new stores are performing well, sounds rational, right?

This is where companies get a chance to manipulate with numbers without getting noticed. The management of the company may alter the criteria of eligible stores to be used in the metric.

For example, in one financial year, a company may use only those stores older than 3 years to show the same store sales performance while in the next year, if the performance of the stores older than 3 years deteriorates, the management may change the criteria and use only those stores that are older than 5 years.

Companies may keep changing their eligibility criteria as per their suitability to present the desired picture.

— ARPU (Average Revenue Per User):

ARPU stands for Average Revenue Per User and is a performance metric generally used by Telecom companies or DTH service providers. Just like same store sales, ARPU can also be used for manipulating earnings of a company.

Most telecom companies, especially in this age of smartphones, not only generate revenue from selling data, but also by selling ad space, and this is where the manipulation begins.

The right way to calculate ARPU is by calculating total revenue generated from data services provided divided by the total number of subscribers.

However, some companies, to show encouraging revenue growth add advertising revenue to the revenue from subscription, thereby falsely boosting the total ARPU.

How to detect if a company is cooking books?

cook the books

So far we have seen why and how companies cook books, but the biggest question is, is it possible to detect these financial shenanigans? How would you know that a company is cooking books?

While detecting some of these financial shenanigans requires a degree in finance, most of them can be traced pretty easily if you just observe carefully.

— Improved Revenue with an absence of Cash Flow:

If the complicated accounting terms are giving you nightmares, and you have no clue what to do, here is something very simple and logical thing you can do. Just Watch out for cash flow.

Increase in revenue of the company should be reflected with an increase in cash flow of the company. If you see operating cash flow declining or stagnant even if the revenue is marching upwards, or if cash flow is much slower than the revenue generated, it usually means that the company is generating revenue but is unable to collect cash, or even worse, the revenue numbers are simply fake and bogus.

— If Q1+Q2+Q3+Q4 is not equal to FY:

In an ideal situation, if the financial results are audited, the annual sales and profits should simply be a sum of all the four quarterly sales and profit numbers, except for minor variations.

If there is a significant variation between annual sales and profit numbers and sum of all quarterly numbers, you can say that the books have been manipulated at least to some extent.

— If a company is on an acquisition spree:

Companies make acquisitions as it helps the acquirers grow inorganically while making an acquisition, companies make sure that the interests of both the companies are aligned and that the resources that an acquiring company needs are available with the company that is being acquired, at a bargain price.

In simple words, any acquisition should add value to the company more than what is being paid for it. There are many instances when companies are on an acquisition spree. Firms that make numerous acquisitions can get into trouble, their financials get restated and complicated to understand.

Aside from complicating things, acquisitions usually increase the risk of cooking books and bury the evidence under many layers of financial statements. So if a company is a serial acquirer, but does not show significant improvement in its financial performance, there is a good chance that the acquisitions were made simply to manipulate the numbers.

— If the company has bulging Trade Payables:

Many companies, especially in a competitive, customer-centric market loosen their credit terms, attracting more customers to buy goods and services now and pay later. While this is a great move that helps boost sales revenue, it may create a liquidity crisis in a company.

Longer credit duration means that company has to wait longer for the revenue to be converted into cash, but since a company has to meet its daily expenses in cash form, longer credit means company may run out of cash and may have to either borrow to meet its operational expenses or shut down its operations completely.

The best way to cross-check if the company’s revenue is simply because of loose credit terms is to check if there is a change in days receivables in the past few financial years.

If a company has increased the receivable days, it shows that all the revenue is just on paper and the cash is yet to be realized. Such practice is pretty common in infrastructure companies.

— If the CFO and auditors resign or get fired:

This is by far one of the most vital signs that a company is cooking books. There is an old saying in Latin “Who Watches the Watchmen?” when it comes to financial reporting, the watchmen are the Chief Financial Officer (CFO), and the corporate auditor.

If you find a company that is involved in some of the suspicious accounting activities as mentioned above, and you see the CFO of the company quitting abruptly for no valid or logical reasons, its time to stand guard and find out if there is something going on within the company that has not met your eyes yet.

The same rule applies to corporate auditors. IF a company frequently changes its auditors or fires them after some accounting issues come to light, be watchful and look for warning signs.

There have been many recent examples of auditors resigning after altercation from the company owners, which later revealed that company was involved in dressing up numbers to make things look good on the surface while it was really bad inside.

In the month of May 2018, Deloitte, corporate auditor of Manpasand beverages quit a few days before the declaration of annual result as the company was unable to share crucial data regarding capital expenditure and revenue. As a result, the stock price of Manpasand beverages tanked 20% within a day. You can read the news by clicking here

Another such incident happened recently where PWC (Price Waterhouse Coopers LLP) statutory auditor of Reliance Capital and Reliance Home Finance, quit just before the declaration of FY19 results.

In its resignation letter, PWC stated that as part of the ongoing audit for FY19, it noted certain observations and transactions, which, in its assessment, if not resolved satisfactorily, might be significant or material to the financial statements. You can read the new by clicking here

Conclusion:

If you are looking for a great investment, look for great businesses. The best way to understand if a business id great or not is by analyzing the financial statements of the company.

Since every investor relies on financial statements for his analysis, it’s important that companies remain honest and transparent and give only authentic information.

However, with the ever-mounting competition, and a race to perform better than peers puts a lot of pressure on the management to perform, because of which they often resort to unethical ways to manipulate the number so that the business “appears” healthy.

There is an Old Russian Proverb which means “Trust, but Verify”, taking things at face value can be dangerous and thus it is important that investors, even if they trust the management with the numbers, should always be vigilant and keep checking the authenticity before making an investment decision, after all, it’s your hard-earned money at risk, don’t take anyone else’s word for it.

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About the Author:

This article is a guest post by Ankit Shrivastava, a SEBI Registered Research Analyst. Ankit has been investing in stocks since 2004 and writes about fundamental analysis of companies, principles of investing, investment strategies and a lot more on his blog: Infimoney

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10 Questions to Ask Before Purchasing a Stock - Investment Checklist!

Picking a winning stock that can give consistent returns for many years requires a lot of analysis and research. However, you can simplify the research process if you have an investment checklist.

Having a reliable checklist for picking stocks can reduce the chances of missing an important detail that you should have studied before investing in the stock. As Charlie Munger, Vice-Chairman of Berkshire Hathaway has famously quoted:

“No wise pilot, no matter how great his talent and experience, fails to use a checklist.” — Charlie Munger

In this post, we are going to discuss ten key questions to ask before purchasing a stock by every stock investor. Let’s get started.

Quick Note: Although there are hundreds of points to check while picking a stock to invest, however, most of them can be categorized among the ten questions listed below. Anyways, by no means, I claim that this is the best checklist for picking stocks. My suggestion would be to study the investment checklist given below, improvise and make your own list of questions. Further, for simplicity, I’ve not included financial ratios.

10 Questions to ask before purchasing a stock.

Here are the ten key questions that every investor should ask before investing in a stock.

1. What does the company do?

What are the products/services that the company offer? Do you understand the company’s business model? How does the company actually make money? What are the top/best-selling products of the company?

2. Who runs the company?

Who are the promoters/owners of the company? It the company a family owned or professionally managed one? Who is managing the company? What are the credentials/background of CEO, MD, Board of directors and the management team? What is the shareholding pattern of the company?

3. Is the company profitable?

How much profits did the company generated in the last few years? How are the company’s gross, operating and net profit and what is the profit margin at each level? Is the profit of the company growing over time or stagnant/declining?

4. Does the company have a sustainable competitive advantage?

Does the company have a moat like intangible assets, customer switching cost, network effect, cost advantages or any other sustainable competitive advantage that can keep the competitors away from eating their profits?

5. How was the past performance of the company?

How is the company’s financials in the past few years? What’s the trend in the company’s income statement and cash flow statement? How are the sales, EBITDA, Cash from operating activities, free cash flow and other financial metrics over the past few years?

6. How strong is the company’s balance sheet?

Are the assets of the company growing over time? How much is the liability of the company? Is the company’s shareholder equity increasing? How much cash do the company have on the asset side? How much is the company’s Intangible assets, Inventories, Receivables, Payables and more? Does the company invest in its Research & Development, especially in a few sectors like Technology, Pharmaceutical etc?

7. Was the management involved in past fraud or scams?

Was the company’s promoters or management involved in any past scam? Does the company has any history of cheating the shareholders or any past penalty by SEBI?

8. Who are the key competitors?

Who are the direct and indirect competitors of the company? What is the market share of the company vs the competitors in the industry? What this company is doing differently compared to its competitors? Are there any global competitors or the possibility of global leaders entering the same market anytime soon?

9. How much debt the company has?

How much short-term and long-term debt the company has? Does the company generate enough profits or Free cash flow to cover the debt in the upcoming years? Have the promoters pledged any of their shares?

10. How is the stock valued?

What is the true intrinsic value of the company? Is the company currently over-valued, under-valued or decently valued? Is the company relatively undervalued compared to the competitors and industry? What is the calculated intrinsic value by different valuation method? How much is the margin of safety? Will you be overpaying if you buy the stock right now?

Also read: How To Select A Stock To Invest In Indian Stock Market For Consistent Returns?

Closing Thoughts:

Although getting a recommendation or investing where friend/colleague suggested may land you into a few profitable deals. But if you want to make consistent returns from the market (and not just being lucky), you need to build your own trustable investing strategy.

It’s true that picking a winning stock required a tremendous amount of research. However, having an investment checklist of questions to ask before investing in stock significantly reduce the chances of investing in fundamentally weak stocks. Moreover, you can easily eliminate over 90% of the companies who don’t meet your checklist.

I hope the questions discussed in this post is helpful to you. If I missed any additional important to ask before purchasing stock in this investment checklist, feel free to mention below in the comment box.

That’s all. Have a great day and Happy Investing!

What is Return on Capital Employed (ROCE)?

Hello Readers! In today’ post, we will be exploring the formula and the concept behind the Return on Capital Employed or ROCE.

The topics we shall cover in the post are as follows,

  1. Formula and calculation
  2. How to calculate NOPAT?
  3. How to calculate Capital Employed?
  4. The conceptual and interpretation of the formula and closing thought

1. Formula and calculation

Return on Capital Employed, as the name states, is the profit generated by the total capital used by the company for its operations for a period. It is widely used as a measure of profitability in the financial and the investment community. Although not commonly used around three decades ago, it has traveled a long way to even occupy center stage in the decision making of some portfolio managers and retail investors.

ROCE is computed as the percentage of Net Operating Profit after Taxes (NOPAT) upon the total long-term capital employed.

Return on Capital Employed = NOPAT / Total Capital Employed

Since the NOPAT is generated over the financial period which the Capital Employed is a balance sheet item and is normally represented at a period in time, some investors argue that the use of ROCE based on average Capital Employed during a period is a better metric.

The calculation for that is as given below

Return on Capital Employed = NOPAT / Average Capital Employed

Where, Average Capital Employed = (Opening Capital Employed + Ending Capital Employed)/2

The denominator of the above expressions implies that ROCE can also be defined as the return earned by the business as a whole or alternatively as the return generated by the capital contributed by both the creditors and the equity holders of the firm together.

In the case where the debt-financed component of capital is very low, the ROCE should give a value closer to ROE for similar earnings than a company which operates with a highly leveraged position.

2. How to calculate NOPAT?

The NOPAT or the Net Operating Profit After Taxes are calculated on the basis of two key inputs, EBIT and the TAX rate. In India, we have a corporate tax rate of approximately 30% for companies with revenues greater than ₹250Cr and around 20% for companies with revenues less than ₹250Cr.

The NOPAT calculation is pretty straightforward and can be done as per the equation below,

NOPAT = Earnings Before Interests and Taxes (1-Corporate Tax Rate)

NOPAT = (Profit before Taxes + interest payments + one time adjustments) (1-Corporate Tax Rate)

The black box here in this equation is the one-time adjustments, this includes earnings and expenses which are not regularly generated through operating activities of the company. These may include litigation expenses, loss/gains from the sale of assets, gain/loss due to asset revaluation of inventory, etc.

(However, if a company makes these kinds of expenses or gain regularly, it would require deeper inquiry on the side of the investor)

3. How to calculate Capital Employed?

The calculation of the denominator part of the equation is fairly simple and can be done from the line items reported on the balance sheet of a company.

Since the Capital Employed as mentioned before refers to the total capital raised from both the debt holders of the firm and also the equity holders, the formula should reflect contributions of both the capital provides to the assets of the company.

Capital Employed = Total assets – Total current liabilities.

This could also be shown as,

Capital Employed = Shareholders Equity + Non-current liabilities

Also read:

4. The conceptual and interpretation of the formula

Most investors in the financial world like to see that the company they are about to invest in has a ROCE value greater than the Weighted Average Cost of Capital or WACC. WACC best defined as the minimum return a company should get subject to its unique capital structure.

If the ROCE of a company is greater than the WACC then the company is said to generating value for its shareholders and it is advised that the shareholders continue to hold the company in their portfolio. If the company’s ROCE is less than WACC then it is said to be destroying shareholder value and since equity holders are the last paid in the preference order of payments it is advised that equity holders stay out of such a company.

The calculation of WACC or the minimum return to be achieved the company is slightly complicated however a non-finance retail investor who could instead compare ROCE by arriving at his own required rate of return.

Since most retail investors may not be familiar with the computation and the vagaries of WACC, we feel it would be beneficial to use the following thumb rule to come up with your own required rate of return.

Required Rate of Return (%) =  (Risk free bond rate + inflation rate + market risk premium) margin of safety

Where the market risk premium refers to the additional premium an investor would expect for investing in markets for most cases it would be better to take a value between 3%-5%.

Assuming an interest rate on a 10-year Indian Government bond is 8.2 percent, inflation rate of around 8 percent, a market risk premium of 3% and a margin of safety of 20 percent,

Required Rate of Return (%) =  (8.1+8 +3) 1.20= 19.1 * 1.20 =  22.9%

Now if a company generates a ROCE greater than 22.9% then the company is creating value at a rate greater than the rate of return we calculated above and could be a target for shortlisting for investments.

Although not entirely foolproof, ROCE provides a lot of insight into the working business model of a company. Furthermore, an investor could gain better insights if he/she were to compare the evolution of the ROCE value for the last 5 to 6 years of company to form an opinion.

How To Evaluate The Cash Of A Business?

You might have heard the phrase ‘Cash is the king’.

A cash-rich business means that the company has enough cash left after paying all its expenses and debts. For the company with high cash, it simply means more liquidity and opportunities for the business.

However, very high cash is also not good for a company as it means that the company is leaving potential investment opportunities. Overall, low cash can affect business stability and high cash can reduce its efficiency.

And therefore, it is really crucial to understand the cash position of business before investing. In this post, we are going to discuss how to evaluate the cash-rich businesses to understand whether the company has low, sufficient or excess cash.

Cash and cash equivalents

When it comes to evaluating the cash position of a company, the investors look into the cash and cash equivalents (CCE) section of the balance sheet.

These are the company’s assets that are cash or can be converted into cash fast. Here, cash equivalents can be defined as the assets that can be converted into cash within 3 months like Money market funds, Short-term Government bonds, Treasury bills, Marketable securities etc.

All cash and cash equivalents are recorded in current assets segment of the balance sheet and are the most liquid asset of a company. Now, let’s understand the two common scenarios with respect to the cash level of a business.

Case 1: Low cash

When a business has low cash, it can be little worrisome for the company as it may have or will face some problems to pay short-term obligations.

In case of sufficient cash, companies can easily settle short-term debts (obligations), make an in-time purchase of new inventories/equipment, buy into lucrative investments/new technology, grab mergers and acquisition opportunities, increase dividends etc.

However, lack of adequate cash may push the company towards potential short-term problems. As a thumb rule, avoid investing in companies with low cash balance.

too much cash

Case 2: High Cash

Although high cash helps a company in staying out of trouble of short-term obligations, supporting regular business operations in tough times, funding in its growth, superior performance etc. However, many times, excess cash be a little unfavorable.

Too much cash in company’s balance sheet simply means that the company is leaving potential investment opportunities to invest in the growth of its business operations or investments in other higher return instruments.

As Warren Buffett used to say- “Cash is the king. But it’s not much help if the king just sits there and does nothing.”

Too much cash reflects the inefficiency of the management to utilize it properly.

How to evaluate the cash of a business?

The cash position of a company can be evaluated using cash to current assets ratio. This ratio reflects the percentage of the total assets by cash and cash equivalents

Cash to current assets ratio = (Cash and cash equivalents)/(Current assets)

Although ideal cash and cash equivalents depend highly on the industry, however, as a thumb rule, cash to assets ratio of more than 40% can be considered to be excessive cash for the company.

Now, let us calculate the cash to current assets ratio of Hindustan Unilever (HUL) from its balance sheet.

HUL Balance sheet

(Source: Yahoo finance)

From the above statement, you can find the cash and cash equivalents (CCE) and total current assets of HUL over the years. For the year ending March 2018, the cash to current assets ratio turns out to be equal to 5.57%, which can be considered decent. (Quick note: You need to check this ratio over the past few years and compare with the competitors to better understand the cash position of HUL).

Also read:

A word of caution:

Although having high cash is good for businesses, but it is equally important to understand the source of that cash i.e. where that cash is coming from?

There are different ways for a company to pile up cash. Apart from the profitability of the business operations, a few other ways to build cash is by taking debt or selling its assets. And both of the later two ways to generate cash is not favorable for a company as a high debt means greater interest obligations. Further, selling the assets to pile up cash may affect the future profitability of the company.

Therefore, you should always check the source of cash for the cash-rich businesses. You can find out this by looking at the cash-flow statement of a company.

In the cash flow statement, check the cash from operating activities. If this is consistently increasing, it’s a positive sign and means that the company is able to generate profits from its core businesses operations. Further, also check the cash from investing activities to find out purchase or sale of assets. Finally, also look into the debt obligations of the company for the long-term and find out its trend over years.

Note: If you are new to the financial world and want to learn how to effectively read the financial statements of companiesfeel free to check out this awesome online course on Introduction to Financial Statements & Ratio Analysis.

Bottom line

The cash of a business can be roughly evaluated by navigating the cash and cash equivalent section in the company’s balance sheet. Here, cash to current assets ratio is used to check the cash level of a company.

A company should have sufficient cash to effectively run its short-term operations. However, huge cash can also be little troublesome for a company as it reflects the management’s inefficiency to use the cash productively.

That’s all. I hope this post is useful to you. Happy Investing!!

What is Working Capital? Definition, Importance & More.

What is Working Capital? Definition, Importance & More.

Hello Readers. One of the most important factors to check while analyzing a company before making an investment decision is its working capital.

In simple words, working capital can be defined as the funds available to a firm to finance its regular operations like day to day business activities. Nonetheless, the noteworthiness of working capital is way more than what most people think. 

In today’s article, we will be focusing on the importance of working capital management and how it could be studied to get a deeper insight into the companies we are researching for potential investments. 

Here are the topics that we’ll cover in this post.

  1. What is working capital?
  2. Why is working capital important?
  3. What factors affect the working capital of a company?
  4. When Negative net working capital is actually positive.
  5. Conclusions

Overall, it’s going to a very educational post. Therefore, please read this article till the very end. Let’s get started.

1. What is working capital?

To define the term in the simplest words, working capital is essentially the funds that have been allocated for day to day operations of the firm for the current financial year. These funds need not entirely be held in cash but could also include any asset or liability from which a cash transaction could be expected. This could include account tradables, cash in hand, account payables and short-term borrowing and loans.

The most commonly used formula for working capital is given by the following,

Net Working Capital = Current Assets – Current Liabilities

When an investor wants to look only at the operating level of a company he may prefer to use the following formula for working capital.

Operating Working Capital = Cash + Inventory + Accounts Receivables – Accounts Payables

Please note that the operating working capital excludes the short-term interest and loan payments a company may have to incur in a financial year.

2. Why is working capital important?

Conventionally, the working capital is used as a measure of a company’s liquidity. Since it is calculated on the basis of accounts receivable/payable, cash, borrowing and payments, the working capital of a company could tell us a ton about the management’s approach and commitment to inventory management, debt management, revenue collection, and payments to suppliers.

A positive working capital would imply that a company has got a good control over its transactions and is able to collect and make payments with a large degree of freedom.

A negative working capital, on the other hand, would normally imply the opposite.

3. What factors affect the working capital of a company?

Although working capital is studied to get an understanding of the management and the general thumb rule that positive working capital is always better than negative working capital works most of the times in investing. We, at Trade Brains, believe that investors could get access to more opportunities if they were to take a more holistic approach to study working capital.

Since a company is always involved in a particular business, it is, therefore, logical to assume that all the short/long term factors affecting the industry will determine how managers conduct their operations and hence the working capital. In some industries, managers can offset the risk in operations by choosing a favorable business model. Depending on the kind of model they choose to operate could also determine the working capital of the company.

On a broad level, the list of factors that can affect the working capital of a company are as below (note that this is not exhaustive but may be used as a guide)

  • Nature and type of business
  • Type of Industry
  • Factors of production and their availability
  • Competition
  • Price levels and inflation
  • Production Cycle Time
  • Credit Policy and agreements with suppliers and customers
  • Growth and Expansion strategies
  • Working capital cycle

A more quantitative approach to analyzing working capital would be through a basic ratio analysis. Below are the most useful metrics used by fundamental investors.

4. When Negative net working capital is not so negative!

Imagine a newspaper printing and distribution company with around 2,000 customers in a city. When a customer signs up for a subscription for 1 year, he/she may have to pay the amount up front for the period for which the service is provided. Assume that the subscription cost for one year is ₹1,000, this implies that the company will receive ₹20,00,000 in advance payment. This amount is recorded under accounts payables portion of the balance sheet. Assume that the company holds another ₹8,00,000 in cash and an inventory worth ₹2,00,000.  The net working capital of the company can then be computed to be -₹10,00,000.

In the above example, it can be noticed that even though the working capital happens to be negative the business model of the company allows the company to receive its cash well in advance. This cash could then be ploughed back into the business as investments into new equipment or into marketing to expand its client base.

In general, companies that have high inventory turns and perform a lot of business on a cash basis, such as grocery stores or discount retailers, require very little working capital. These types of businesses raise money every time they open their doors. Because of their advantages, these company can also enter into contracts with vendors and suppliers to lend their products for free for a specified period of time. These partnerships allow the retailers/discounters to keep their cash in hand and employ them elsewhere which trying to sell the products they got through credit. If they are unable to sell them they could just return it back to the vendors before the end of their negotiated period without any cost.

The following sectors are normally observed to operate with a negative working capital.

  • Retail: Due to supplier agreements and high inventory turnover
  • FMCG: Able to leverage their wide brand appeal and customer demand to get retailers to book their products in advance
  • Automobiles: Companies employ “just in time” manufacturing policies to keep efficiency high and inventory at low levels. Also, they normally charge a decent sum as an advance from customers as booking charges.
  • Media: Services are provided only after an upfront subscription fee

5. Conclusions

Although analyzing the working capital and its various components form an essential part of investment research. An investor should always keep in mind to view the company as a business and try to understand the root causes within the business model or the industry which drive the numbers.

Sticking to an individual’s circle of competence may help greatly in this regard which investing in stock markets. Happy Investing!

Why is a VALUE TRAP? The Bargain Hunter Dilemma!

Have you ever bought a cheap stock, which later got cheaper and cheaper? If yes, then you might already have met with- Value traps.

Value traps are those stocks which may seem like a value stock because of their cheap valuation. However, in actual, they are garbage stocks. Unlike value stocks, these value traps do not have true potential to give good returns to their investors and that’s why their price keeps on declining for a continued period of time.

Why do investors fall in value trap?

There are some stocks which may appear cheap because they are trading at a low valuation metrics such as PE, price to book value ratio, cash flow ratio etc.

The bargain hunters keep an eagle eye on these stocks as they appear cheaper compared to their historical valuation or relative to the market.

These investors buy these stocks at a low price considering them as a value stock. However, the problem arises when the price keeps on dropping for an extended duration of time.

Here, instead of purchasing a value stock, the investor has fallen for a value trap.

Also read: #9 Things I Wish I had Avoided During my Initial Days in Stock Market.

VALUE TRAP 4

What actually is a ‘value trap’?

The value traps are those stocks which are ‘not’ cheap because the market has not realized their true potential or because of some temporary setbacks. These stocks are trading at a cheap valuation because the company has either lost its fire or else its fire is fading away.

A value trap is that stock which is not able to generate any significant profit growth or revenue. A few of the general reasons for the underperformance may be rising production/operational cost, declining market share, lack of new product/services, change in competitive dynamics or inefficient management.

The investors who buy such stocks just by evaluating its low valuation (without giving any regard to the reason why the valuation is low) falls in the value trap.

Also read: Why Warren Buffet Suggests- ‘Price Is What You Pay, Value Is What You Get’?

Real value stock vs value traps

The real value stocks are those stocks which are trading below their intrinsic value. The reason for their cheap valuation may be either temporary factors or because the market has not yet realized their true potential.

Few common characteristics of value stocks are consistency, strategic advantage, strong business plan, growing cash flow and high-quality financials. Further, these stocks can be considered value stocks only if they are bought at a significant margin of safety by the value investors.

On the other hand, value traps are those stocks that are trading at a low valuation because of long-term or permanent setbacks (factors).

These stocks are not actually trading below their intrinsic factor. They are just trading at a low valuation compared to their historical valuation or relative to the market (which might be even above its true intrinsic value).

Value trap stocks lack catalysts or momentum to retrace its original growth track.

Also read: SWOT Analysis for Stocks: A Simple Yet Effective Study Tool.

Common traits of value traps:

Although these value trap stocks might be trading at a low valuation compared to its past valuation or market, however, the chances of these stocks bouncing back to their historical valuation are quite low.

Most of the value trap stocks suffer from lack of innovation, degrading competitive advantages, high debt, low-interest coverage potential, poor management, declining profitability and no future growth prospects. Proper research is required while investing in these cheap stocks to understand the reason behind their low valuation.

For example- if the average PE of an industry is 18x and stock is trading at 5x, then considering the PE valuation, it might look like a value stock. However, whether its actually a value stock or a value trap can only be found after proper investigation.

Similarly, if a banking company is trading at a price to book value of 4x compared to the industry average of 9x, then again the bargain hunters first need to investigate the reason behind the low valuation of that stock before concluding it as a value stock.

Also read: Why You Should Invest Inside Your- Circle of Competence?

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Here are a few common signs that the cheap stock is actually a ‘Value Trap’:

1. Declining earnings:

If the earnings and cash flow of a company are consistently declining for past few couples of years, then the stock might be a value trap. The low valuations of these stocks are because of their dull future prospects. The market works on future expectations and if investors cannot see any future growth potential in the company, then the stock might even degrade further, no matter how low is the valuation.

2. Business plan:

A company with outdated technology or a non-profitable business cannot be a value stock. Take the examples of the 2G/3G technology based telecommunication companies. Most of such companies ran out of business just because of outdated technology.

3. Poor Management:

A poor and inefficient management of a company is a sure sign of a value trap. If the management lacks the driving force and their strategic vision is cloudy, then the investors of that company might suffer from value traps.

4. High Debt:

Huge debt and leverages are never favorable for a business. A big debt is an actual trigger for the most deadly value traps.

5. No change in management compensation structures:

If the earnings have declined and still the management keeps on giving huge bonuses to their top management structures, then definitely they have not adapted to address the problem. During declined earnings or troubled times, a company needs to change their fundamental behavior in order to get back in the race.

6. Poor financials and accounting principles:

The financial accounts should be clear and transparent enough to give the true snap regarding the company. If the accounting of a company is not credible, they might be hiding some financial difficulty or even solvency.

7. No change in capital allocation method:

With the shift in the scenarios, the company needs to change its capital allocation method like how much capital they want to allocate in their growth, dividends, capital expenditure or to get rid of a big debt.

8. Strategic disadvantages:

Declining market share, declining competitive advantage, and company not being able to contain its costs are again a few big signs of a value trap.

9. No growth catalysts:

When the company starts moving in the wrong direction, it might need some kind of catalysts to move back to the growth track. These catalysts can be new innovations, products/services or even earning growth. If the company is lacking any sign of growth catalyst, then again that cheap stock might be a value trap.

Also read: 11 Must-Know Catalysts That Can Move The Share Price.

Although, there can be a number of other signs that a company is a value trap, however, these nine are the top signs.

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Summary:

The actual goal of a value investor is to avoid value traps. Therefore, my first suggestion to every value investor would be to research the stock properly before investing.

However, even seasoned investors sometimes fall into the value trap and buy garbage stocks considering them undervalued.

In such a situation, the best you can do is to understand the problem and cut off the stock as soon as possible. Do not purchase more stocks in order to average down or hold the stock long enough with an expectation to break even. The faster you can get rid of that stock, the better it is for you.

In the end, let me tell you the law of holes: “If you find yourself in a hole, stop digging”.

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