Goal-based investing, also known as Target based investing or Goal-driven investing has been into a lot of buzzes lately. The name itself defines this investing strategy.
However, still many investors do not know what exactly is a goal-based investment and how to pursue it. In this post, I’ll try to answer the most frequently asked questions regarding goal-based investing. Here are the topics that we’ll discuss today:
What is a goal-based investing?
How is goal-based investing different from traditional investing?
Why goal based investing is the key to long-term success?
How to get started with goal-based investing?
This post may change the way you look towards investing. Therefore, make sure that you read this article till the end. Let’s get started.
1. What is a goal-based investing?
Although goal-based investing is not a new concept and many financial experts have been following this strategy over a long period, however, it started getting fame recently.
Goal-based investing is a new way of wealth management where the individuals focus on attaining specific objectives or life-goals through their investments. Here, before starting to invest, the individual tries to answer the question- “What exactly are they investing for?”.
The best part about the goal-based investing is that here the investors do not focus on getting the highest possible returns. But the aim of this investment is to reach the desired returns that meet their goals.
In a goal-based investment, the individuals periodically measure the progress on their returns against the specific goals. Instead of trying to outperform the market, they try to attain their goals within the desired time horizon.
Moreover, the goal can be person specific like planning for children education, retirement fund, buying a new house or even financial independence. A few factors included while planning goal-based investments are the aim of the person per age, risk tolerance, financial situation, and investment horizon.
2. How is goal-based investing different from traditional investing?
The main motive of traditional investing is to get higher returns and generally to beat the market.
Here, the individuals compare their returns with the index such as Sensex or nifty in order to find whether their personal investments are over or underperforming.
On the other hand, goal-based investing redefines the success based on the individual’s goals and needs, rather than whether they beat the market or not. This strategy tries to shift traditional investing to a personal financial goal approach and helps to invest based on needs and risk tolerance.
The problem with traditional investing is that they do not focus on the individual’s needs. In such a scenario, no matter, how good are the returns, if the individuals are not reaching your final goal, then the returns might not be good enough for the individuals. After all, investing is a long-term activity and NOT a phenomenon of beating the market for a year or two.
Goal-based investment allocates the funds depending on the individuals’ situation and aims. For example- if your goal is retirement, then you might choose a conservative strategy with a majority of investments in debt funds. On the other hand, if your goal is to build a corpus for your children’s marriage, you might choose an aggressive strategy with 50% investment is equity and rest 50% in debt.
3. Why goal based investing is the key to long-term success?
The biggest advantage of goal-based investing is that it increases the individual’s commitment to invest consistently in order to reach their life goals. Unlike traditional investing, here the individuals participate actively and observe the progress towards their goals.
Moreover, having a long-term strategy helps the individuals to avoid making impulsive decisions based on market fluctuations. As the individuals are more focused to achieve their goals, they are less inclined to make spontaneous decisions just with an expectation to get a little higher return. Goal-based investing prevents rash investment decisions by providing a clear process of identifying goals and choosing strategies to achieve them.
Lastly, it also avoids the situation of under-saving (and under-investing). As goal-based investing continuously monitors the progress of individuals towards their goal, and hence they remain updated on how far they are from their goals. In a case where they are under-investing, they can re-improvise their strategy so that they can reach their goal in time.
Although planning a goal-based investing requires a detailed study of the individual’s goals, financial situation, time-horizon, and risk tolerance. However, here are a few simple steps that can give you a rough idea of how to get started.
The first step is to clearly define your goals and the time horizon to attain them. The goal can be building a corpus for buying a new house, savings for children education/marriage, retirement etc. You can even have multiple goals and differentiate them as short-term, mid-term and long-term.
The next strategy is defining your strategy of where you’ll invest and how. Depending on the risk-tolerance, required rate of return and time horizon, you can choose different funds like equity, debt or a combination of both. Further, you also need to decide your monthly, quarterly or yearly contribution to all these funds.
The next step is to be disciplined in following your strategy. To attain your goals, you need to make consistent investments.
Finally, periodically monitor and review your progress towards your goal. If your progress is not in line with your purposes, you might need to revise your strategy and re-allocate your funds so that you can reach your goal in time.
Goal-based investing is a relatively new way to achieve personal needs by investing in a definite strategy. It’s a good alternative over traditional investing which does not focus on the individual’s goals and financial situation.
Most individuals start investing in the market without any goal. There are even a few who invest in the market just for fun and to make a few extra bucks alongside their primary income source. And it’s perfectly okay to start like that. However, with time you need to eventually decide a goal for your investments. It will help you reach them in time and to avoid situations of taking unnecessary risks just in order to get some extra returns.
Besides, another benefit of goal-based investing is that it helps in ‘Guilt-free spending’. Here, as you already know that all your goals have been taken care of, you can spend the additional income on something that you love without any guilt.
Final thoughts, “Investing is good. But it is even better when attached to a goal.”
Although becoming a large-cap company is a dream of most of the businesses, however, after becoming a mature company, many companies find it a little challenging to maintain their growth.
Moreover, the problem arises when they are not able to sustain their profitability and starts declining. There are a number of examples of companies which were once a market leader, however, couldn’t keep a sustainable profit margin and later either shut down or went bankrupt. The most common example is Kingfisher.
Declining companies do not have much growth potential left and even the returns (and value) of their existing assets keep on sinking.
Therefore, as investors, it’s really important for us to continuously monitor the growth of our invested company. And if we are able to find some signals that the company is declining, it might be the time for exit from them.
After all, no matter how much we love our invested company, the main goal of our investments is to make money and if the company is continuously declining, there’s no point remaining invested. It’s really difficult for the declining companies to reward their shareholders. Further, we as investors have thousands of other options available to invest in the market. Then, why to stick with the declining companies?
In this post, we are going to discuss three clear signals that you can study from the financial statements which show that a company may be declining.
Besides, these financial signals are very simple to identify (even for the beginners). Therefore, make sure that you read this post till the very end. Let’s get started.
3 Financial Signals that a company may be Declining.
Although evaluating the exact financial health of a company requires a serious study of the statements of profit & loss, balance sheet and cash flow statement of the company. However, there are a few financial tools which send an easy signal for the investors to identify the declining companies. If all these three financial signals are negative for a company, then the company might be in a little trouble.
Here are the three simple financial signals that you can study to evaluate if a company is declining:
1. Declining Revenue:
If a company’s revenue is continuously declining for the past multiple years, it may be a warning sign for the investors.
The revenue of a company is the TOP LINE of the income statement. And if the TOP LINE is declining, in general, all the lower levels will follow the same trend.
Even a stagnant (flat) revenue for a continued longer period of time is a sign of caution for the investor. After all, there’s a fixed extent up to which a company can control its expense. And if the company want to increase its profit, then it has to increase its revenue eventually.
A flat or declining revenues for past multiple years is an indicator of operating weakness. Moreover, if you can find that the revenue of the competitors (and the industry) is growing over the same perio, then it sends even a stronger signal of a weak management and poor health of the company.
For example- here is the income statement of Reliance communication for the last five years. Here, you can easily notice the declining net sales (and total revenue) for the past multiple years.
And this decline is in line with the stock return of this company. In the last five years, Reliance communication’s share price has shrunk by over 88%.
2. Negative Profit margin:
If the profit margin of a company is negative, it shows that the company is not able to generate profit from its regular business. A negative or declining profit margin of the company for a continued longer period of time can be taken as a warning sign for the investors.
Declining companies generally lose their market share to their competitors. And in order to keep up their sales, they often have to either give bigger discounts or to cut their profits. Moreover, they also lose the pricing power which further leads to a fall in the margin.
While evaluating companies, you can look into the three level of the profit margins- Gross profit margin (GPM), Operating profit margin (OPM) and Net profit margin (NPM), each being a more refined level of profitability. As a rule of thumb, avoid investing in companies with a negative profit margin.
Anyways, if you’ve already invested and now find that the profit margin of the company is continuously declining for the past multiple years, then it might be a signal that this company is declining.
3. Big dividend payouts:
Dividend payout is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company.
It can be calculated by dividing the dividend per share (DPS) by earnings per share (EPS) of a company in a year. For example, if the DPS of a company for the current year is Rs 2 and its EPS is Rs 10, then the payout ratio is equal to 2/10 i.e. 20%.
If a company gives a consistent dividend to its shareholder, it is a healthy sign.
However, the problem arises when the company starts paying a major portion of its net income as dividends. In such a scenario, the company is not retaining enough income for investment in its growth or future plans.
There should be a balance between rewarding shareholders and the retaining income for its own growth. After all, if the company is not investing enough in itself, it will eventually become difficult for them to increase (or to maintain) their profitability in the future.
Declining companies generally pay out large dividends to their shareholders as they have a very little need (or scope) of reinvestment. As a rule of thumb, payout ratio greater than 70% for a company can be a warning sign for the investors.
Other financial signals:
Another financial tool that can give you a better picture of the financial situation of a company along with the above three financial indicators is the company’s debt level.
If the debt level of a mature company is continuously increasing at a high pace, it is a sign that the company has been aggressively financing its growth with debt. You can use debt to equity ratio to evaluate the debt level of a company. A high debt to equity ratio (greater than one) can be considered a high risk for the company.
Even big mature companies are capable of declining over time and losing their value. And that’s why, it is important for the investors to continuously monitor the growth of their invested company.
In general, a flat or declining revenue, negative profit margin and huge dividend payout can be considered signs of a declining company.
Anyhow, if the company takes necessary steps, it may recover back on track or even become a turn-around. However, if the management doesn’t take the significant steps in time, the company may decline further destroying the shareholder’s investment.
Evaluating the intangible assets of a company is a crucial part of the fundamental analysis, especially in a generation with a lot of leading companies in the technology and service-based industries.
However, most investors ignore this part and focus more the physical assets like land, building, equipment etc. One of the major reasons why people skip the part of studying intangible assets is because these assets are a little difficult to evaluate. After all, how would you correctly measure the value of a brand or non-physical assets of a company?
In this post, I’ll try to demystify intangible assets in simple words so that you can understand what exactly are intangible assets, why are they valuable for a company and how can you evaluate the intangible assets of a company.
Overall, it’s going to be an exciting post. Therefore, please read it till the end because I’m sure it will be helpful to you in assessing companies better.
What are intangible assets?
Intangible assets are those assets that are not physical in nature, yet are valuable because they contribute to the potential revenue of the company.
A few of the common examples of intangible assets are brand recogintion, licenses, customer lists, and intellectual property, such as patents, franchises, trademarks, copyrights etc.
Quick Note: Contrary to these, TANGIBLE Assets are those assets that have a physical form. For example- land, buildings, machinery, equipment, inventory etc. Further, financial assets such as stocks, bonds etc. are also considered tangible assets.
Although intangible assets do not have an obvious physical value such as land or equipment, however, they can be equally valuable for a company for its long-term success or failure.
For example, companies like Apple or Coca-Cola are highly successful because of the significant brand equity. Since it is not a physical asset and tricky to calculate the exact value, still brand equity is one of the primary reasons for the high sales of these companies. In India, companies like Hindustan Unilever, Colgate, Patanjali, etc also enjoy benefits of enormous brand value.
Further, a few more examples of intangible assets can be marketing-based (ex- Internet domain names, non-competition agreements etc), artistic-based (ex- literary works, musical works, pictures etc), Contract-based (ex- franchise agreements, broadcast rights, use rights etc) and technology-based (example- computer software, trade secrets like secret formulas and recipes etc). [Credits: Examples of intangile assets- Accounting tools]
Moreover, in a few industries, intangible assets are more valuable.
Unlike manufacturing companies where inventories and fixed assets contribute to the majority of their total assets, in a few industries the intangible assets are more valuable:
Consumer product companies depend on the brand name. For example- Hindustan Unilever, Godrej, Colgate, etc. The bigger the brand name, the easier are the sales.
Technology companies get the most success by their technical know-how and skilled human resource. Ex- Infosys, TCS, etc.
Banking companies have their computer software license, stock exchange cards and electronic trading platform (websites). Ex- HDFC bank.
Telecom industries use their bandwidth licenses (including spectrum) to enjoy benefits. Example- Bharti Airtel
Drugs and pharmacy companies protect their sales through patents, which means that they can sell unlimited medicines of patented drug and their competitors can’t enter or replicate the same. Ex- Dr. Reddy’s Laboratory, Glenmark Pharma etc.
And that’s why, the leading companies in these industries spend a lot of money in building these intangible assets.
For example, in the IT industry, training and recruiting are more prominent than investing in physical assets like buildings.
Similarly, the pharmaceutical companies spend a lot of capital in the Research and development (R&D) which may help them get a patent on a revolutionary drug. And that’s why, while evaluating companies in this industry, the capital expenditure of the different companies/competitors in their R&D work should be carefully evaluated.
If you look into the consumer product companies, they spend a lot of money in advertisement just for brand awareness. Although, this may not lead to instant sales and may add overhead expenses, However, over the long term. branding help these companies to generate more profit.
Valuing Intangible Assets:
Intangible assets of a company can be found on the asset side of the balance sheet of a company. For example- here is the intangible assets for Hindustan Unilever (HUL)
You can use the intangible to total asset ratio to evaluate the worth of intangible assets in a company. For example- in the case of Hindustan Unilever, its intangible assets make around 2.05% percent of its total asset.
However, valuing intangible assets are easier said than done. One of the biggest reasons equipment high sales of HUL in India is its prominent brand recognition. A few of the popular brands of HUL are Lux, Lifebuoy, Surf Excel, Rin, Wheel, Fair & Lovely, Pond’s, Vaseline, Lakmé, Dove, Clinic Plus, Sunsilk, Pepsodent, Closeup, Axe, Brooke Bond, Bru, Knorr, Kissan, Kwality the and Pureit.
Here, do you really think that the brand value of HUL contributes only around 2% of its net assets? I don’t think so. It must be worth more. However, there’s no easy way to correctly evaluate the worth of the brand recognition and other non-physical assets.
Quick fact: According to Forbes, COCA COLA’s brand value amounted to 57.3 billion U.S. dollars. It is the only company in the top seven list that sells carbonated sugar water beverages. Rest all are technology companies with Apple and Google as leaders. This is the power of branding. Read more here: The world’s most valuable brands.
Although intangible assets do not have a physical presence, they add a huge value to the company. There may be even cases where the intangible assets are of far greater value than the market value of the company’s tangible assets.
However, while valuing such companies, you may have to put some efforts to study these assets as the accounting conventions do not always value the exact worth of a few intangible assets and they may be reported below their true value in the balance sheet.
Any how, look for the intangible assets that are definite (i.e. stays with the company for as long as it continues operations) and difficult to replicate.
While performing the fundamental analysis of companies, two of the most common strategies to research stocks that are used by investors are top down and bottom up approach.
In this post, you’ll learn what exactly is top down and bottom up approach, how they work and which one may be more suitable to you.
Top down approach
Have you ever heard any investor/analyst saying something like- “The electric vehicle industry looks particularly promising now. The industry is growing at a fast pace and I should invest in this industry”.
Well, here the investor is following the top down approach to find stocks.
In the top down approach, the investors first look into the macro picture of the economy and later work down to research the individual stocks.
The overall steps involved in top down approach is to first look at the big picture of the world i.e. which economy is doing great, then look at the general market in that economy, next find the particular sector that may outperform and finally research the best stock oppotunity to invest within that sector.
For example, let’s say you studied that the European economy is growing at a very fast rate. Next, when you looked further into the European market, you found that especially the biotechnology industry in outperforming. And finally, you researched some appealing stocks in that industry to invest. This is the top down approach for stock investing.
Here, you start with the big picture and ultimately move down to find the suitable investing opportunity. Top down approach looks at the performance of the economy & sector and believes that if the industry is doing good– the chances are that the stocks in that industry will perform too.
A few of the major areas where the top down analysts pay attention are economic growth, GDP, monetary policy, inflation, prices of commodities, bond yields etc before moving into the specific industry study.
The biggest advantage of top down approach is that there’s no pre-conceived notion about what may work and the selection of economy, industry & stocks are based on the real-time studies. Further, as they focuses on the strong sectors, the chances of underlying companies performing well are favorable.
However, one of the major flaw of top down approach is that here you may miss out a few good bargain stocks in the eliminated industries.
This approach is exact opposite of the top down approach. Here, you first start with company research and later move up to find the other details.
Bottom up approach tries to study the fundamental of the company regardless the market conditions, industry or the macroeconomic factors. While performing the bottom up approach, the investors studies how fundamentally strong the company is by focusing on its revenues, earnings, financial ratios, products/services, sales growth, management etc.
The key here is to find the potentially strong company which may outperform the industry and market in future. If the fundamental factors are good, then regardless of what the industry is doing, the bottom up investors will pick such companies to invest.
The biggest advantage of the bottom up approach is that the investors may find the best potentially strong company which can outperform even if the economy or industry as a whole declines. Bottom up approach helps in picking quality stocks.
On the other hand, one of the cons of bottom up approach is that the investor may have some pre-conceived notion of the company and in such condition, their investment decisions may be a little biased. Further, as these investors ignore the longer economic influence and market conditions, some investment returns may be adversely affected because of these factors.
Top down and bottom up are entirely different approaches to analyze and invest in stocks. However, both have their own advantages and disadvantages.
The top down approach first looks at the broader economy and macroeconomic factors, and then move to the specific industry and the company within. On the other hand, bottom up approach starts at the company level and later moves up for the other important details.
In general, top down approach can be little easier for the less experienced investors as they do not have to perform the intense stock research and analysis. They can start studying the most appealing industry and find the companies within to invest.
Anyways, both approaches have their own effectiveness and hence, difficult to say which one is better. Moreover, it also depends on the knowledge and preference of the investor. My final advice would be to better try out both the approaches and find out which one suits you the best for your investment strategy.
SWOT Analysis for stocks is one of the most widely used tools for performing the ‘qualitative’ study of the company. It helps to understand the company’s market position and competitive advantages.
In this post, we are going to discuss what is SWOT analysis and how to use this tool for qualitative analysis of a stock.
What is SWOT Analysis?
SWOT Analysis focuses on four important factor while evaluating the quality of a company. Here’s what SWOT Analysis for stocks looks at:
Our of the four factors of SWOT analysis, ‘strength’ and ‘weakness’ are the internal factors of a company and hence are controllable.
On the other hand, ‘opportunities’ and ‘threats’ are external factors and it’s little difficult for a company to control these factors. However, using the SWOT analysis of stocks, the management can identify the threat and opportunities and hence can take proper actions within time.
Those automobile companies who have already realized this big opportunity might have started working on the BS-IV vehicles months before the expected launch date. On the other hand, companies who haven’t done the opportunity/threat analysis properly would have faced a lot of troubles. They cannot sale the old BS-III model vehicles. Hence, a big loss of the finished products and the inventories.
Quick Note: During swot analysis for stocks, only include valid/verifiable statements. Do not add rumor/misleading pieces of information in the study.
Components of SWOT Analysis for stocks:
The strength of a company varies industry-to-industry. For example, a low non-performing asset (NPA) can be the strength of a banking sector company. On the other hand, cheap supplier or cost advantages can a big strength for an automobile company.
Here are few other strengths of a company that you should take notice while performing SWOT analysis of stocks:
The ‘reverse’ of everything discussed in the ‘Strengths’ can be the weakness of a company. For example- Weak financials, in-efficient management, poor brand recognition, unskilled workforce, non-repetitive clients, un-scalable business and disloyal customers.
Besides, there are few other weaknesses that may affect the company:
Lack of capital
For example- many companies in telecommunication industry ran out of business as they were using outdated 2G/3G technology. Similarly, in the energy sector, renewable power generation is the future technology and those companies who are ‘not’ working on the new technology might get outdated soon. In short, outdated technology adversely affects most of the industry.
A company with a lot of opportunities has a lot of scopes to succeed and make profits in future. Here are few points that you need to consider while evaluating opportunities for a company:
Internal growth opportunity- (New product, new market etc)
In order to survive (and moreover to remain profitable), it’s really important for a company to analyze its threats. Here are few of the biggest threats to a company:
Changing consumer preferences/ new trends
Unfavorable Government regulations
The changing consumer preferences are one of the repetitive threats that many industries face. Here, if no proper action is taken to retain the customer, then it might unfavorably affect the profitability of the company.
For example- The new trend of ‘health awareness’ among the people may result in a decline in the sales of beverages/Soft drink companies. (These companies are fighting back this threat by introducing ‘DIET-COKE’).
Similarly, a preference towards ayurvedic products in India has already reduced the sales of non-ayurvedic FMCG companies (and a rise of PATANJALI).
SWOT Analysis of stocks is a useful tool to analyze stocks based on their strengths, weakness, opportunities, and threats. If done properly before investment, SWOT Analysis can help an investor to understand the competitive advantages/disadvantages in order to make a reasoned decision.
Have you ever had a chance to participate or witness an auction?
If yes, then you would relate to this better! As interesting as the name of this phenomenon sounds, the outcomes are pretty relatable too.
Many statisticians, mathematicians, and successful investors have discovered and scribbled a pretty common sequence of scenarios that happens mostly during the auction. Let’s try to give you an overview of this:
A bidder sitting in an auction and trying to repeatedly bid on an asset often gets intimidated to continue his bidding even if it is not profitable.
As obvious, in such scenarios, the last one to bid gets the asset and hence gets the title of “the winner”.
But has he actually won? What do you think? The inference can be a bit deeper than you are assessing it to be.
Such scenarios are quite noticeable everywhere – from IPL auctions to jewelry auctions to the real estate to the stock market, you might get to see this every time. The phenomenon could be explained clearly with the use of a couple of suitable examples in this article.
“Winner’s Curse” is quite noticeable in the domain of investing. Generally speaking, a newbie tends to fall in such pitfalls quite often! Keep reading this article to know more about the winner’s curse!
If you haven’t had a chance to witness an auction yourself then you have a chance to virtually experience it over here!
Basically, an auction is a set up organized by the “current owner” of an asset who is interested in selling the asset to one of the bidders who are participating in the auction. The owner can be a bank or any other financial institution as well.
A set of people who are interested in purchasing the “on sale” entity are called bidders who have the leverage of placing the bids on the entity. The bidding starts with a base price (the one put forward by the “current owner”) and the bidders have to one-up their biddings to own the asset/entity.
The mentioned set of actions is repeated until no bidder out rules the last bidding. As a result, the final bidder gets the asset – sound simple?
Where is the loophole?
Suppose if the real (true value) price for the asset was 1 hundred thousand dollars and if the final bidder claims it for two hundred thousand dollars, would he still be called as a winner?
Psychologically speaking, the overwhelming and competitive environment of bidding in an auction makes the bidder claim the entity at a higher price than what is profitable (admissible).
This overestimation of the final bid for an entity is actually the cause of “winner’s curse”.
New to stocks? Confused where to begin? Here’s an amazing online course for beginners: ‘HOW TO PICK WINNING STOCKS?‘ This course is currently available at a discount.
What triggers this curse?
They say, “Emotional stability is one key factor when it comes to investing”.
You would have seen various collaborations of multinational companies. In fact, the whopping amount for which the shares for a certain company get sold is quite huge, right? Well, the winner’s curse is actually playing the cards for it sometimes.
In fact, various multinational giants get caught in this trap. Is it emotional friction or winning at any cost? I’d say both.
The human brain works in a pretty competitive way and the reason can be delved into the core of cognitive science. After the “successful bidding” one gets to realize the loss incurred but the dust gets settled by then.
A rapid increase in an entity’s price followed by its contraction is a sequence followed by various financial experts. The strategy works when a number of people get lured by the so-called “lower prices” of the assets and end up paying for it.
Winner’s curse is not new to the stock market. You can notice multiple scenarios in the stock market where the investments of the people are influenced by the winner’s curse. Few of the best examples are:
1. Buying stocks at a high price.
In the stock market, every now and then, you may come across a storyline where people are buying expensive stocks because they don’t wanna lose the opportunity. Here, they are ready to bid a huge price to win that stock. However, purchasing an overvalued stock (only for the sake of winning) is never advantageous for the investors.
2. Investing in IPOs where the insiders are selling their stakes and public is bidding.
IPO is a scenario where a company offers its shares to the public for the first time. During an IPO, insiders like Promoters, Family, Early Investors- Angel capitalist, Venture capitalist etc are selling their stakes to the public.
However, do you really think that the insiders will sell their stakes to the public at a discount?
Anyways, in order to win, the public is ready to bid a high premium (most of the time) for that IPO. However, after the IPO gets allotted to the people, the winner’s curse starts playing its role.
You might want to steer clear of this the next time you go for a hefty investment, right? Don’t worry you can try out some precautionary measures with which you should do fine at the “war zone”.
Things to Remember while Bidding:
1. Just as analysis and research are two important things to do before making an important investment. Similarly, knowing the true value of the asset you are bidding for is quite important before you even go for it. You should know that you stick to your actions even better once you have the basics cleared in mind.
There must be a fair standard price of the commodity you’d be bidding for. Get to know about it beforehand.
2. Draw a line:Putting aside an emotional mindset is the best thing that you can do while bidding for an asset as emotions and finance don’t mix well together. As soon as you start placing your first bid, you should know where to draw the line. This would help you hold your grounds in a much better way.
3. Know how important it is for you to win: Rational arguments are always better when you are in a confused state of mind. Ask yourself why does winning actually matter to you?
Everyone who enters the stock market wants to make money from their investments. And in order to do that, first, they need to understand how people really make money from stocks. Basically, there are two ways to make money from the stock market.
Capital Appreciation (Buy low and sell high)
When it comes to capital appreciation, most of the people knows this method to make money from stocks. Purchase a good stock at a low valuation and wait until the price goes up. The difference in the purchase and selling price is the profit (capital appreciation).
This is the core principle of value investing. Find an amazing stock at a cheap valuation and hold it for a long time until the market realizes its true/real value.
However, there is also a second method to make money from the stock market which is (generally) ignored by most newbie investors. It is called dividends.
In this post, we are going to discuss how to make money from dividends -the right way.
Important terms to learn regarding dividends:
Before we dig deeper, first you need to learn few important terms regarding dividends-
Dividends: Dividends are the profits that a company shares with its shareholders as decided by the board of directors.
Dividend yield: Dividend yield is the ratio of annual dividend per share divided by the price per share. The formula for dividend yield is given below:
Dividend yield = (Dividend per share/ price per share)
For example, if a company gives an annual dividend of Rs 10 and its current market price is Rs 200, the dividend yield of the company will be 10/200 = 5%.
Here are the annual dividends of few famous companies in India (2017).
Hdfc bank – Rs 11 per share
Coal India – rs 19.90 per share
Hindustan Unilever – Rs 17.00 per share
Reliance Industries- Rs 11 Per share
Ongc- Rs 6.05 per share
Now, if you calculate the dividend yield given by the above companies, you may find it very small.
If a company gives a dividend yield of 2% per year, it’s really difficult to build a livelihood using this income, right? For example, if you want an annual income of Rs 2 lakhs in dividends, then you have to invest Rs 1 Crore in that stock. This is not feasible for most of the average Indian investors.
However, there’s an important lesson that you need to learn here—
Dividends increase over time…
This means that a good fundamentally strong company will increase its dividends with time.
For example, if a healthy company gives a dividend of Rs 10 this year and makes more profit in upcoming years, then it will increase its dividends in future.
Another important lesson to learn here is that– your dividends are going to increase. But your purchase price is going to remain constant throughout your holding time frame.
Therefore, if you look at the dividend yield, the numerator (dividends) is going to increase with time. But the denominator (purchase price of the stock) is going to remain constant for you. In short, the dividend yield for that stock is going to increase in future.
Let us understand this better with the help of an example.
How To Make Money From Dividends?
Suppose you purchased 100 stocks of a company at Rs 200. The annual dividend for that year was Rs 10. So, for the first year, the dividend yield will be 5%. This yield is small here compared to the returns from most of the debt investments.
Nevertheless, let us assume that the company is fundamentally healthy and going to give a consistent (increasing) dividends in the upcoming years. Here is a table describing the annual dividends in the upcoming years.
Total Annual Dividends
Moreover, along with the dividends, your capital will also appreciate in value as you are holding the stock for a long time. In the next 5 years, maybe the purchase price of Rs 200 has now appreciated to Rs 400, 500 or whatever high price.For the investors, who buy that stock directly in the fifth year (at an appreciated price- let’s say Rs 500), the dividend yield for them might be low. However, for you have purchased that stock long ago at a decent price, the dividend yield will be quite high (even higher than the fixed deposits).From the above table, you can notice the increase in the dividend yield as the dividend increases.
In short, here dividends are allowing you to receive a healthy income without selling your original assets.
The biggest point of concern regarding dividend stocks is that dividends are not obligations. This means that the company may reduce or discontinue the dividends in future.
For example, if a company suffers a heavy loss in a year or if the company is planning to invest its profit in some new project/plant, then it might reduce the dividends or do not give any dividends to its shareholders.
Therefore, if you are investing in any dividend stock, then first make sure to look at the dividend history of that company. A consistently increasing dividend for the last 10-12 years can be considered a healthy sign.
How to incorporate the Dupont analysis while researching stocks?
As investors in the stock markets, it is important to find high-quality along with fairly valued companies to invest our capital. The rationale behind this is simple. Our aim in the markets is to always preserve our capital first and then produce profits.
There are several robust tools that investors use during their stock analysis.
In this post, we will make an attempt to share one such powerful framework to assess the quality of stocks that we target for our portfolio -The Dupont Analysis.
The topics we shall aim to cover are as follows-
What is the DuPont Analysis? Who made it?
The technical background of the DuPont Analysis.
Real world DuPont Analysis of Eicher Motors
The post should be an easy read and we hope our readers find this to be of great value to their time. Feel free to reach out to us or post comments in case of any doubts or clarifications.
1. What is the DuPont Analysis? Who made it?
DuPont analysis was created around the 1920s by Donaldson Brown of Dupont Corporation. Initially, when Brown invented the framework it was used for assessing the managerial efficiency of the company before it got adopted by public market investors. His genius was breaking down the formula for Return on Equity (ROE) into its constituent parts to analyze the root cause of ROE.
2. The technical background of the DuPont Analysis
Breaking ROE into its constituents helps us investors analyze the company’s business model and how it manages to achieve excess returns for its shareholders.
Since most investors (including Warren Buffett) use ROE to judge the quality of a stock it would be of great use to us to understand how deep “Quality” actually runs within the business.
To understand how the analysis technique is used let’s start with the very basics. As most of us already know, Return on Equity (ROE) is calculated from the following formula –
Now, our friend Brown brown multiplied and divided the expression to get the following–
This expression is now also summarised as below-
But Brown did not stop there, he took this expression and went one step further. This time he multiplied and divided the expression with Total Assets to give us the DuPont formula-
Which is again summarised as,
From the last expression, it becomes clear that ROE is not merely a ratio (as per the formula we started with) but a framework to understand the business and capital position of the company as a whole.
Valuable insights can be derived from knowing which of the attributes drives the rise or deterioration of ROE over a period of time.
It can also be used to compare companies with their peer sets to get a deeper understanding of the differences in the business models between the companies.
Let us perform the DuPont analysis on Eicher motors for the period 2014-2018.
The summary table and the evolution of the three attributes from the analysis is as given below.
Net Profit Margin
From the table, we can see that the company has improved its ROE from 19.2% to 27.9% in 5 reporting periods.
We can also see that the company decreased its leverage and asset turnover but this drop was offset by close to 3.7 times rise in the net profit margins.
Further, notice that the leverage ratio has been stable since 2016 while asset turnover has seen a drop in 2015-2016 and then moderate decreases from 2016-2018.
This analysis can now set the foundation for further analysis, the questions raised from the above figures could be as below ( this may not be very exhaustive but may give an idea as to how the framework is used)-
What is causing the decrease in asset turnovers? Is it because of rising inventory? A fall in efficiency? Or perhaps a decrease in capacity utilisations at manufacturing facilities?
Is the Net Profit Margins led by rise in prices or decrease in costs of goods sold?
What caused the spike in net profits and the corresponding drop in asset turnover?
Answering the above questions in additions to questions generated by assessing the financial statements could help the investors analyze Eicher Motors in greater depth.
Since ROE is used as a measure of the quality of management by many investors, the incorporation of DuPont Analysis could help quell any illusions developed by using ROE at face value.
According to DuPont formula, ROE is a function of net profit margins, asset turnover, and the leverage ratios. A rise or dip in ROE could be because of a corresponding rise/fall in any of these metrics and hence a high ROE doesn’t always indicates a better performance.
Our readers are advised to use DuPont Analysis along with the other stock evaluation frameworks and not to solely depend on data provided by the financial websites.
That’s all for this post. I hope it was helpful to you. Happy Investing!!
“… but blue chip companies are boring. It’s better to invest in growth stocks with huge upside potentials.”, Gaurav argued energetically.
“Yes, blue chips are not the ‘hot’ stocks in the market. However, they are a good option for the investors who are looking for low-risk investments with decent returns.”, I replied.
Gaurav has been investing in the stock market for the last two years and he likes to discuss his investment strategies with me. Nevertheless, his investment style is totally different from that of mine. Gaurav loves to invest majorly in mid-caps and small-cap companies (including penny stocks) which can grow at a fast pace. On the other hand, I like investing in a diversified portfolio.
“That’s true, dude. But most of these blue chip companies have already reached a saturation point. They can not continue to grow at the same pace and hence can’t similar returns as they used to give in the past. Once a company has sold a billion products, it’s difficult to find the next billion customers.”, Gaurav challenged me with his witty reply.
“I know the rule of large numbers, Gaurav. Thank you for reminding me. Moreover, I agree that the large-cap companies cannot maintain the same pace of growth forever. But bro, it doesn’t mean that they won’t be profitable in future or can’t give good returns to their shareholders… They have already established their brand. If they use their resources efficiently, they can make huge fortunes for themselves as well as for their shareholders…
For example- take the case of Reliance Industries. Reliance is a market leader in its industry and has a lot of customers. But they are also using their capital efficiently to grow their business. Two years back, they entered a new market- Telecommunication Industries, and now they are also a leader in that industry.
Because of their strong financials- they were able to bring the latest 4G technology to the Indian market and hence were able to quickly acquire a lot of customers. As the initial set-up cost in this industry is very high, they have created an entry barrier for the small and mid-cap companies. This is what a blue-chip company can do if they use their resources properly.“
Gaurav looked a little mind-boggled. That’s why I thought better to give him another example to make him understand the capabilities of blue chip companies.
“Let’s discuss another example- Hindustan Unilever. If you think that HUL cannot grow any further because it is a large-cap company, then you might need to reconsider it. HUL already have popular products in the market like Lux, Lifebuoy, Surf Excel etc which are generating them a good revenue from those products. But, they still have a large rural area to cover. They are not so popular in the village areas, are they? So, they can definitely grow in the rural areas…”
…besides, as they have enough resources and financials, they are also continuously working on new product development in their Research & development (R&D) department. If they can make another great product, their profits will add-up in the future….“
Finally, when Gaurav didn’t argue further, I concluded-
“…a good blue chip company is like Rahul Dravid. If you want fast scorers (or T-20 players), then you may not like his batting style. However, if you are looking for dependable players, then you will definitely appreciate Rahul Dravid’s consistency.”
However, there is one particular type of stocks which gets a lot of attention from every kind of investors (beginners to the seasoned players)- and they are the BLUE CHIP stocks. In this post, we are going to discuss what are blue chip companies and the ten best blue chip companies in India. Here are the topics that we will cover in this post-
What are the blue chip companies?
Why are they called blue chips?
Key characteristics of blue chip companies.
10 Best Blue chip companies in India.
This is going to be a long post, but I promise that it will be worth reading. So, without wasting any further time, let us understand the blue chip companies in India.
What are Blue Chip companies?
Blue chip companies are large and well-established companies with a history of consistent performance. These companies are financially strong (usually debt-free or very low debts) and are capable to survive in the tough market situations.
Most of the blue chip companies are the market leaders in their industry. Few of the common examples of blue chip companies in India are HDFC Bank, ITC, Asian Paints, Maruti Suzuki etc.
Signature Characteristics of Blue Chip Companies-
Here are few signature characteristics which you can look forward while researching blue chip companies—
They are large reputed companies.
They have a widely used products/services.
Most of these companies are listed in the market for a very long time.
Blue chip companies have survived a number of bear phase, market crisis, financial troubles etc. But they are still going strong.
Blue chip companies have a strong balance sheet (a large number of assets compared to liabilities) and a healthy income statement (revenues and profits continuously growing for the last few decades).
These companies have a good past track record of stable growth.
Almost all blue chip stocks are older companies. You might already know many of the blue chip companies in India and have been using their products/services in your day-to-day life.
For example- Lux, Lifebuoy, Surf Excel, Rin, Wheel, Fair & Lovely, Pond’s, Vaseline, Lakmé, Dove, Clinic Plus, Sunsilk, Pepsodent, Closeup, Axe, Brooke Bond, Bru, Knorr, Kissan, Kwality Wall’s and Pureit —- all these products are offered by the same blue chip company in India – Hindustan Unilever (HUL).
New to stocks? Confused where to begin? Here’s an amazing online course for beginners: ‘HOW TO PICK WINNING STOCKS?‘ This course is currently available at a discount.
Why are they called blue chips?
Oliver Gingold- who worked at Dow Jones, is credited to name the phrase ‘Blue Chip’ in 1923. The term ‘blue chips’ became popular after he wrote an article where he used ‘Blue chips’ to refer the stocks trading at a price of $200 or more.
Quick Note: There are other sets of investors who believe that blue chip companies got its name from the Poker game, as in that game- blue chips are relatively more valuable. Similar to the game, the stocks which are more valuable in the market are termed blue chip stocks.
Although Oliver Gingold used the term ‘blue chips’ for high priced stocks, however, later people started using this word more often to define high-quality stocks (instead of high priced stocks).
What are the financial characteristics of blue chip stocks?
Apart from the signature characteristics discussed above, here are few key financial characteristics of blue chip companies –
1. Blue chip companies have a large market capitalization -As a thumb rule, the market cap of most of the blue chip companies in India is greater than Rs 20,000 Crores.
2. Good past performance: Blue chip companies have a track record of good past performance (like consistently increasing annual revenue over a long-term).
3. Low debt to equity ratio: The bluest of the blue chips are (generally) debt free stocks. However, a lower and stable debt to equity ratio can also be considered as a significant characteristic of blue chip companies.
4. Good dividend history: Blue chip companies are known to reward decent dividends to their loyal shareholders.
5. Other characteristics: Apart from the above four- few other key characteristics of blue chip companies are a high return on equity (ROE), high-interest coverage ratio, low price to sales ratio etc.
Now that you have understood the basic concept, here is the list of top 10 best blue chip companies in India. (Disclaimer- Please note that the companies mentioned below are based on the author’s research and personal opinion. It should not be considered as a stock recommendation.)
Indian Tobacco Company (ITC) is one of the biggest conglomerate company in India. ITC was formed in August 1910 under the name of Imperial Tobacco Company of India Limited. It has a diversified business which includes five segments: Fast-Moving Consumer Goods (FMCG), Hotels, Paperboards & Packaging, Agri-Business & Information Technology. Currently, ITC has over 25,000 employees.
As of 2016, ITC Ltd sells 81 percent of the cigarettes in India. Few of the major cigarette brands of ITC include Wills Navy Cut, Gold Flake Kings, Gold Flake Premium lights, Gold Flake Super Star, Insignia, India Kings etc.
Apart for the cigarette industry, few other well-known businesses of ITC are Aashirvaad, Mint-o, gum-o, B natural, Sunfeast, Candyman, Bingo!, Yippee!, Wills Lifestyle, John Players, Fiama Di Wills, Vivel, Essenza Di Wills, Superia, Engage, Classmate, PaperKraft etc.
HDFC Bank is India’s leading banking and financial service company. It is India’s largest private sector lender by assets and has 84,325 employees (as of March 2017).
HDFC Bank provides a number of products and services which includes Wholesale banking, Retail banking, Treasury, Auto (car) Loans, Two Wheeler Loans, Personal Loans, Loan Against Property and Credit Cards. It is also the largest bank in India by market capitalization and was ranked 69th in 2016 BrandZ Top 100 Most Valuable Global Brands.
Infosys Limited is an Indian multinational corporation that provides business consulting, information technology and outsourcing services. It has its headquarters in Bengaluru, Karnataka, India.Infosys is the second-largest Indian IT company by 2017 and 596th largest public company in the world in terms of revenue. On April 19, 2018, its market capitalization was $37.32 billion.
Infosys main business includes software development, maintenance, and independent validation services to companies in finance, insurance, manufacturing and other domains. It had a total of 200,364 employees at the end of March 2017.
HUL is one of the largest Fast Moving Consumer Goods (FMCG) Company in India with a heritage of over 80 years. It is a subsidiary of Unilever, a British Dutch Company. HUL’s products include foods, beverages, cleaning agents, personal care products, and water purifiers.
Few famous products of HUL are Lux, Lifebuoy, Surf Excel, Rin, Wheel, Fair & Lovely, Pond’s, Vaseline, Lakmé, Dove, Clinic Plus, Sunsilk, Pepsodent, Closeup, Axe, Brooke Bond, Bru, Knorr, Kissan, Kwality Walls and Pureit.
Nestle India is a subsidiary of Nestle SA of Switzerland- which is the world’s largest food and beverages company. It was incorporated in the year 1956. Nestle India Ltd has 8 manufacturing facilities and 4 branch offices in India. The Company has continuously focused its efforts to better understand the changing lifestyles of India and anticipate consumer needs in order to provide Taste, Nutrition, Health and Wellness through its product offerings.
Few famous products of Nestle India are Maggi, Nescafe, KitKat, MUNCH, MILKY BAR, BARONE, NESTLE CLASSIC, ALPINO etc. (On 8 March 2018, Nestle Indias food brand MAGGI completed 35 years of existence in India.)
Eicher Motors is an automobile manufacturer and parent company of Royal Enfield, a manufacturer of luxury motorcycles. Royal Enfield has made its distinctive motorcycles since 1901 which makes it the world’s oldest motorcycle brand in continuous production. Royal Enfield operates in over 40 countries around the world.
The Eicher Group has diversified business interests in design and development, manufacturing, and local and international marketing of trucks, buses, motorcycles, automotive gears, and components.
This company needs no introduction. Reliance Industries is an Indian conglomerateholding company and owns businesses across India engaged in energy, petrochemicals, textiles, natural resources, retail, and telecommunications.
In December 2015, Reliance Industries soft-launched Jio (Reliance Jio Infocomm Limited) and it crossed 8.3 million users as of January 2018.
Reliance is one of the most profitable companies in India and the second largest publicly traded company in India by market capitalization. On 18 October 2007, Reliance Industries became the first Indian company to reach $100 billion market capitalization. It is also the highest income tax payer in the private sector in India.
Asian paint is one of the largest Indian paint company and manufacturer. Since its foundation in 1942, Asian paint has come a long way to become India’s leading and Asia’s fourth-largest paint company, with a turnover of Rs 170.85 billion. It operates in 19 countries and has 26 paint manufacturing facilities in the world, servicing consumers in over 65 countries.
Asian Paints is engaged in the business of manufacturing, selling and distribution of paints, coatings, products related to home decor, bath fittings and providing of related services.
Tata Consultancy Services Limited (TCS) is an Indian multinational information technology (IT) service, consulting and business solutions company.It was established in 1968 as a division of Tata Sons Limited. As of March 31, 2018, TCS employed 394,998 professionals.
TCS is one of the largest Indian companies by market capitalization (Rs 722,700 Crores as of June 2018). It is now placed among the most valuable IT services brands worldwide. TCS alone generates 70% dividends of its parent company, Tata Sons.
Bajaj Auto is a global two-wheeler and three-wheeler Indian manufacturing company. It manufactures and sells motorcycles, scooters and auto rickshaws. Bajaj Auto was founded by Jamnalal Bajaj in Rajasthan in the 1940s. It is the world’s sixth-largest manufacturer of motorcycles and the second-largest in India.
Few of the popular motorcycle products of Bajaj Auto are Platina, Discover, Pulsar and Avenger and CT 100. In the three-wheeler segment, it is the world’s largest manufacturer and accounts for almost 84% of India’s three-wheeler exports.
Most people invest in blue chip companies become of their long history of consistent performance and a similar expectation of standard performance in the future. Blue chip companies are low-risk high return bet for the long term.
Many blue chip companies in India like Tata, Reliance, Infosys etc are considered as ‘Too-big-to-fail’ companies as they have survived and remained profitable for a very long time. Nevertheless, this is not always true!!
And in this post, I am going to share a few of my learnings regarding what exactly is financial independence and early retirement (FIRE) and why you should sign up for this movement.
I hope you are also as excited as I’m. Let’s get started.
What is Financial Independence and Early Retirement (FIRE)?
Let me start with a question. If I ask you to think about a retiree, what picture comes in your mind? If you are like me, then most probably the picture is of your grandparents.
In general, most people dream of financial independence or retirement only by the age of 50s or 60s. After all, thinking about early retirement might even sound insane to people who are living pay-check to pay-check and have a number of dependents (like spouse, children, parents etc) to support.
However, time and again, a lot of ordinary people with similar financial situations like that of us- have proved that financial freedom can be achieved even at a comparatively young age if people have a definite plan and are ready to put some serious efforts.
“Financial Independence and Early Retirement (FIRE) is a lifestyle movement that aims at reducing expenditures and increasing investments in order to quickly achieve financial freedom and retirement at an early age.”
In simple words, the two terms described in FIRE can be explained as:
Financial freedom — which is a financial situation where an individual does not have to work for the sole purpose of making money anymore.
Early retirement — is a situation of quitting your job/career and pursuing other activities that you’re passionate about.
Anyways, most FIRE enthusiast does not always look forward to quitting their job and not working at all. However, after attaining financial independence, one can be picky about their job and choose whether they want to continue working or not. Nonetheless, people who sign up for FIRE targets to become financially free in their 40s, 30s and sometimes even in their 20s.
This movement has got a lot of momentum in recent years. A lot many people are signing up for FIRE- who want financial freedom and early retirement to pursue what they always want to do when they still are young enough to enjoy it.
Does FIRE mean the same for everyone?
Although both financial independence and early retirement are crucial steps, however, both side of the equation of FIRE may not be always balanced for different individuals.
Many people prefer financial freedom over early retirement. Some may even plan to work at the same place when they are financially free just because they enjoy doing it. However, financial independence gives them a choice to choose whether to work or not.
Moreover, how much net worth is required to attain financial independence also varies from people to people. As a rule of thumb, if your net worth is greater than 25 times your annual expense, then you might be financially free.
However, many individuals choose a higher factor just to give a benefit of the doubt in case of unforeseen emergencies.
Who is FIRE for?
In the general population, there is a myth that FIRE can only be achieved by people who earn a lot of money. And I agree to a little. After all, making huge money obviously helps towards the path of attaining financial freedom.
However, this is not the only requirement. In order to obtain financial freedom, one also needs to optimize his spending habits.
FIRE can be more easily attainable for those people who can save money and are willing to follow a disciplined path. Even if you do not earn a huge income, still you can reduce your expenses, build other sources of income and invest intelligently to grow your net worth.
Overall, attaining FIRE depends more on the willingness to develop a financial freedom road-map and sticking to a plan. Moreover, it’s not much difficult if you are ready to make some small but significant optimizations in your life.
The basic principle behind FIRE.
The basic principle behind attaining financial independence and early retirement is very simple-
Spend less than what you make – This is the method used to make a big distance between your income and spending, which most people fail to do.
Invest your savings: By investing intelligently, you can make your money work for you and let it grow with time using the power of compounding.
Anyways, deciding where to invest can be a personal preference. You can choose different investment options depending on your risk appetite like stocks, bonds, index funds, rental properties, real estate etc.
Actionable steps to reach FIRE:
Here are the five actionable steps that can help you to work towards conquering financial independence and early retirement:
1. Figure out WHY you want to attain FIRE.
This might be the most crucial question to ask before you start your journey of financial freedom- Why do you want to attain FIRE?
The reason can be as simple as to spend more time with your loved ones, to travel or to start a long-dreamed business with your pals etc. However, it’s really important that you figure out your why. Having a definite reason will help you keep motivated to pursue FIRE and to stick with your plan.
2. Track your expenses
The next step is to track your monthly (and annual) expenses by looking at your bank statements, credit card statements, and other bills. This will help you out to find how much you are spending and moreover, where exactly you’re spending each month.
Tracking your expenses will also guide you to figure out whether your expenses are meaningful or you are just spending recklessly. Quick Note: You might be a little shocked after calculating your expenses. Generally, it is way higher than what an individual roughly calculates in his mind.
3. Figure out what your lifestyle may cost you per year
After tracking your expenses, you need to figure out how much are your annual expenses and what net income you will require to live a lifestyle that you want to pursue. (Quick tip: Keep in mind about inflation while doing your calculations.)
4. Start working to optimize your expenses and to increase your savings
Once you have figured out your expenses and how much you need annually to start living your preferable lifestyle, then start working to increase your savings. You can cut back the small but significant expenses and optimize your spending so that you can save to the fullest. A few ways to reduce your expenses and save more:
Purchasing used car instead of a brand new.
Lowering your house costs/maintenances
Avoiding frequent visits to restaurants.
Buying monthly groceries instead of frequent visits to the supermarket.
Adding secondary sources of incomes etc
Although these steps are known and quite straightforward, still they are effective to reduce your spending and to increase your savings.
5. Invest your savings
The final step is to spend your savings intelligently in the different investing options which can give you the best possible returns.
Anyways, always keep in mind your risk appetite while selecting the investment option. For example, if you are not much comfortable in taking higher risks, then you can invest in bonds or index funds. On the other hand, if you are young and willing to choose slightly riskier options to get higher returns, direct investment in stocks can give you great returns.
While making decisions, plan your investments in such a way that your future assets should be enough to generate sufficient income for you so that you do not need to work any longer.
Quick Note: Although saving money is considered as the hardest step to attain FIRE, however in actual, the toughest one is to keep patience. After all, it might take years for your money to compound to the level to attain financial freedom. And all that time, you have to avoid the urge to reckless spend your money. And therefore, an individual requires a lot of patience to stick to his plan over long-term.
Although many people have publically shared how they achieved their financial freedom and retired early through their blogs/articles, still FIRE is a relatively new concept in this society which believes that working continuously from their 20s to 50s is the only way to live a successful life.
Moreover, different people have different versions of FIRE. This movement basically means to live frugally and make your money work for you in order to attain financial freedom and to retire from your full-time work as soon as possible. However, not everyone has the same expectations from it. For example, whether one wants to go for a mini-retirements, part-time retirement or permanent retirement after attaining financial freedom- it totally depends on the individual’s preference.
Anyways, although it’s not easy to achieve financial freedom and retire early, however, it is practical and achievable even by people making average salary by building a financial plan and strictly adhering to it.
That’s all for this post. I hope you’ve enjoyed reading it. Finally, if you are also a financial independence and early retirement enthusiast, then spread the FIRE among your friends and family. Cheers!!
Why should you invest in the Stock Market in your 20s?
For the people who are in their 20s- stock market investing might seem too early. Plenty of years left to invest, right? Why get involved in the complex world of the stock market so soon? Most youngsters believe that either it is too soon or they do not have too much money to start investing in their 20s.
However, both of these assumptions are wrong.
The best time to start investing in the stock market is when you are in your 20s. Why? Let’s find out!!
Why should you invest in the Stock Market in your 20s?
1. Stock market investing gives the best returns:
Do you know that if your parents have invested Rs 10,000 in the stocks like WIPRO or Infosys in the early 1990s, it’s worth would have been turned out to be over crores by now? (Here’s a case study on WIPRO and Infosys). Note that we are not even talking about hidden gems. Few other common stocks like Eicher Motors (Royal Enfield Parent Company), Symphony, Page Industries (Jockey) etc has given even better returns than Infosys and WIPRO.
Historically speaking, the stock market has outperformed all the other investment options in the long run. If you buy an amazing stock in your 20s and have the patience to hold it for long-term (20-30 years), you can also get a fantastic return. Here, you’re giving your investment enough time to grow.
2. You won’t require extra money anytime soon.
When you are in your 20s, you won’t need to worry about a lot of things like kids, house loans, kids college fees, retirement plan etc. Moreover, at this phase of time- most of the people do not have any dependents like spouse or kids. When you invest in your 20s, you won’t require to sell that stock anytime soon. You can easily invest and forget that money.
3. It’s a great way to plan your future goals.
Planning to buy a beach house by your 30s or become a millionaire by 40s or just having enough saving to retire early — all these can be achieved if you start investing early. Set a definite future goal in your 20s and invest systematically to attain it.
4. You can take a lot of risks.
When you are in your 20s, you can take a lot of risks while investing in stocks.
Instead of investing in just large caps or blue-chip stocks, you can also invest in small caps like promising startups which recently got listed in the stock exchange and have a huge upside potential. Although, the risk associated with small caps are relatively high compared to the well settled and trustable large caps- however, the rewards are also higher.
When you are in your 20s – even if you incur some loss, you have plenty of time to learn and recover from your mistakes. At this stage of time, while you can handle more risks you can also earn great rewards.
It’s always advantageous to start investing early. One of the greatest investors of all time started investing at an age of eleven.
“I made my first investment at age eleven. I was wasting my life up until then.” -Warren Buffet
Eleven might be a little soon for an average investor in India. However, the 20s is most suitable to start investing in the stock market. At this stage, most of the people have money with no responsibilities.
In the end, here is the golden rule of investing to make build amazing money in the long term—“Invest early, invest consistently and invest for the long term…” #HappyInvesting.
Share market is a place where one can sell you a one-liter packet of milk for Rs 1,000 and if you might be even happy to purchase that. It’s completely impossible to decide whether a stock is overvalued or undervalued just by looking at the market price of the company.
And that’s why valuation is a crucial factor while deciding whether to invest in a stock or not. You do not want to purchase a stock at ten times its valuation. After all, a good company may not be a good investment if you are overpaying for it. It’s always preferable to invest in stocks when they are trading below their true (intrinsic) value.
In the words of the legendary investor Warren Buffett, the intrinsic value of a company can be defined as —
“The intrinsic value of a company is the discounted value of the cash that can be taken out of a business during its remaining life.” — Warren Buffett
Nevertheless, evaluating the value of a company using this definition is easier said than done. After all, finding the intrinsic value of a stock requires forecasting the future cash flows of a company which needs a lot of calculated assumptions like growth rate, discount rate, terminal value etc.
Anyways, one of the most popular approaches to find the intrinsic value of a company is the discounted cash flow (DCF) analysis. In this post, we are going to discuss the step-by-step explanation of how to find the true value of a stock using the DCF method. Further, we’ll also perform the DCF analysis on a real-life company listed in the Indian stock market to find its true value.
Quick note: I’ll try to keep the explanation as simple as possible so that you can easily understand the fundamentals. Let’s get started.
Discounted cash flow valuation:
Before we start the actual calculations, let’s quickly discuss what exactly is discounted cash flow analysis.
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity.
DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. A present value estimate is then used to evaluate the potential for investment. (Source: Discounted Cash Flow (DCF)– Investopedia)
In other words, discounted cash flow analysis forecasts the future cash flow of a company and later discounts them back to their present value to find the true intrinsic value of the stock (at the time of calculation).
Further, I would also like to mention that valuing stocks using the DCF method requires a little knowledge of a few common financial terms like free cash flow, discount rate, growth rate, outstanding shares etc. Here is a quick walk through the key inputs required in the discounted cash flow analysis.
Key inputs of Discounted Cashflow Valuation:
1. Free cash flow (FCF): Free cash flow can be defined as the excess cash that a company is able to generate after spending the money required for its operation or to expand its asset base. It’s important for an investor to look into the free cash flow of a company carefully because it is a relatively more accurate method to find the profitability of a company than the company’s earnings. Free cash flow of a company can be calculated by using the below formula:
FCF = Cash flow from operating activities — capital expenditures
2. Growth Rate: It is the expected rate at which the company may grow in the upcoming 5–10 years. It’s really important to use a realistic growth rate for efficient calculations. Else, the calculated intrinsic value might be misleading.
Different investors use different approaches to find the expected growth rate of a company. Few of the common ways are by looking at the historical growth rate for the earnings/profits, reading the analysts reports to find out what they are forecasting, peeking in the company’s annual report/latest news to find out what the management/CEO is saying regarding the company’s growth rate in upcoming years etc.
Quick Note: In the book- ‘The little book of valuation‘, the author Aswath Damodaran has used an interesting method to find the growth rate of a firm. He argues that for a firm to grow, it has to either manage its assets better (efficiency growth) or make new investments (new investment growth). He used the multiple of proportion invested and return on investment to arrive at the growth rate in earnings. If you haven’t read his book, it is a good place for the beginners to start learning valuation of stocks.
3. Discount rate: The discount rate is usually calculated by CAPM (Capital asset pricing model). However, you can also use the discount rate as the rate of return that they want to earn from the stock. For example, let’s say that you want an annual return rate of 12%, then you can use it as the discount rate.
As a thumb rule for the discount rate, use a higher value if the stock is riskier and a lower discount rate if the stock is safer (like blue chips). This rule is in accordance with the principle of the risk-reward which claims a higher reward for a higher risk.
4. Terminal Multiple Factor: This is the fourth input of the DCF calculation that is used to find the terminal value of the company. Terminal value is the estimated value of a business beyond the explicit forecast period. It is a critical part of the DCF model as it typically makes up a large percentage of the total value of a business.
There are two approaches to the terminal value formula: (1) perpetual growth, and (2) exit multiple.
In this post, we are going to use the exit multiple approach. This approach is more common among industry professionals as they prefer to compare the value of a business to something they can observe in the market. The most commonly used terminal factor is EV / EBITDA. (Read more here).
Steps to value stocks using DCF Analysis:
Here are the steps required to value stocks using the discounted cash flow valuation method:
First, take the average of the last three years free cash flow (FCF) of the company.
Next, multiply this calculated FCF with the expected growth rate to estimate the free cash flows of future years.
Then, calculate the net present value of this cash flow by dividing it by the discount factor.
Repeat the same process for the next 10 years to find the net present value (NPV) of the future free cash flows. Add the NPV’s of the FCF for all the ten years.
Next, find the terminal value the stock by multiplying the final year FCF with a terminal multiple factor.
Add the values from step 4 and 5 and adjust the total cash and debt (mentioned in the balance sheet of the company) to arrive at the market value for the entire company.
Finally, divide the calculated number in step 6 by the total number of outstanding shares to arrive at the intrinsic value per share of the company.
If the final intrinsic value of the company is lower than the current market price of the share, then it can be considered undervalued (and a good time to invest in that stock assuming the quality of the stock is also amazing).
On the other hand, if the final intrinsic value of the company is greater than the current market value, then the stock might be over-valued. In such a scenario, it’s better to keep that stock in the watchlist and wait for the price to come down within the purchase range.
That’s all. This is the exact approach used to find the discounted cash flow value of any company.
In any case, if you are not comfortable in performing DCF valuation using excel sheets, you can also use the Trade Brains’ online DCF calculator to find the intrinsic value of a stock.
Real life example of valuing stocks from Indian stock market using DCF analysis.
Now, let’s calculate the Intrinsic value of Ashok Leyland (NSE: ASHOKLEY) using the Discounted Cashflow Valuation method. (Please note that all the data used here has been gathered from Annual reports.)
First, we will start by finding the free cash flow of Ashok Leyland. Here, we’ll take the FCF for the last 3 years and consider their average as a reasonable FCF. Now, free cash flow is equal to cash from operating activates minus the capital expenditures. The average FCF for the last three years turns out to be Rs 1715 Cr.
Next, we’ll project this FCF only for the upcoming ten years. Although, the company may continue for many more years after the tenth year, however predicting free cash flow for over 10 years is really difficult. Therefore, we assume that the company will sell off all its assets at the end of year ten at a ‘Sell off valuation’ (Terminal value). We’ll use a multiplier of 9 for the tenth year cash flow to simulate the value of these cash flows in the case company would sell all its assets (This is a necessary assumption that we need to make in order to find the value of the company).
Apart from the cash flows, the next important input is cash and cash equivalents which the company reflects on its balance sheet. For Ashok Leyland, this value is equal to Rs 993 Cr.
Besides cash, the next essential input is the debt (as debts have to be first paid off and shareholders are last in the line). Ashok Leyland has a total debt of Rs 515 Cr.
Next, we need to find the annual growth rate for Ashok Leyland. From the historical reports, we’ll consider a conservative growth rate of 12.75% per annum for our calculations of forecasted cash-flow.
Further, here we are considering a discount rate of 13.5% for discounting the future cash flows to their present value.
In addition, we need the total numbers of outstanding shares of Ashok Leyland. It is equal to 294 Crores.
Finally, let’s take a margin of safety of 10% on the overall calculated intrinsic value to give our calculations a benefit of doubt. (Higher the margin of safety, lower is the risk).
After placing the above values in the online DCF Calculator, the intrinsic value per share of Ashok Leyland turns out to be Rs 93.19 (after a margin of safety of 10% on the final intrinsic price). This is the true value estimate per share for Ashok Leyland at the time of writing using the DCF model.
The current stock price of Ashok Leyland is at Rs 105.55. This means that this stock is currently slightly overvalued compared to the calculated intrinsic price.
Quick Note: This intrinsic value is based on my calculations and assumptions. Although I’ve tried to be reasonably conservative in using the inputs, still no valuation should be considered precise as there is no guarantee that the company will grow at the assumed growth rate for the upcoming years. The key while performing DCF is to always consider rational inputs to arrive at a roughly correct intrinsic value.
Now that you have understood how to value stocks using the DCF analysis approach, let me give you a FAIR WARNING. DCF is a very powerful tool for valuing stocks. However, this methodology is only as good as the inputs.
For example, even a small change in inputs (like growth rate or discount rate) can bring large changes in the estimated value of the company. (Try changing these values by 1% or 2% and you can notice a significant change in the result). In short, if the inputs are not reasonable, the out will also not be correct -’Garbage in, garbage out’.
Therefore, fill all the inputs carefully as they all have the potential to erode the accuracy in the estimated intrinsic value.
DCF method is a very powerful method of valuing stocks. However, this method requires rational inputs.
Many investors who have already made up their mind to purchase a stock, can easily infiltrate the final result by assuming a higher growth rate/ terminal value or a lower discount rate. However, if you are choosing wrong or unrealistic inputs for growth rate, discount rate etc, the final intrinsic value per share may also be incorrect. Therefore, it is always recommended to use conservative inputs while performing DCF valuation.
That’s all for this post. I hope it is useful to you. If you have any questions, feel free to comment below. Happy Investing.
**Investing for Beginners**
If you are new to investing, you can learn how to perform stock valuation and pick profitable shares for consistent returns in the Indian stock market with Trade Brains flagship course ‘How to pick winning stocks’. It is a self-paced online course with lifetime access so that you can learn on your own schedule. This course is currently available at a discount. Check out more here. Happy investing!!!
How to find intrinsic value of stocks using Graham formula?
Valuation is one of the most important aspects while investigating any stock for investing. A good business might not be a good investment if you overpay for it. However, most valuation methods like DCF analysis, EPS valuation, dividend discount model etc requires little assumptions and calculations.
Luckily, there are also a few valuation methods available that are pretty simple to use in order to find the true value of a company.
In this post, we are going to discuss one such valuation method which is really straightforward and simple to use. And this valuation method is known as Graham formula. Here are the topics that we are going to discuss today:
A brief introduction to Benjamin Graham
How to find the intrinsic value of stocks using Graham formula?
Pros and cons of graham formula.
Real life example of valuing stocks from Indian stock market using graham formula.
Overall, this post is going to be really helpful for all the beginners who are stuck with the valuation of stocks and want to learn the easiest approach to find the true intrinsic value of companies. Therefore, make sure to read this post till the end.
Let’s get started.
1. A brief introduction to Benjamin Graham
Benjamin Graham was a British-born American investor and economist. He was a sincere value investor and often credited for popularizing the concept of value investing among the investing population. Graham was also:
Graham was a strict follower of value investing and preferred purchasing amazing businesses when they were trading at a significant discount.
In his book- Security analysis, Benjamin Graham mentioned his formula to pick stocks which become overly popular among stock market investors for valuing stocks since then.
2. How to find the intrinsic value of stocks using Graham formula?
The Original formula shared by Benjamin Graham to find the true value of a company was
V* = EPS x (8.5 + 2g)
V* = Intrinsic value of the stock
EPS = Trailing twelve-month earnings per share of the company
8.5 = PE of a stock at 0% growth rate
g = Growth rate of the company for the next 7-10 years
Anyways, this formula was published in 1962 and was revised later to meet the expected rate of return as a lot concerning the market and economy has changed since Graham’s time to present. The revised Graham formula is:
During 1962 in the United States, the risk-free rate of return was 4.4% (this can also be considered as the minimum required rate of return). However, to adjust the formula to the present, we divide 4.4 by the current AAA corporate bond yield (Y) to make the formula legit.
Presently, the AAA corporate bonds are yielding close to 4.22% in the United States. (Source: YCharts). In order to make an apple to apple comparison, we’ll consider the bond yield for 1962 and current yield- both for the United States. Therefore, you can consider the value of Y equal to 4.22% currently, which may be subjected to change in the future.
Quick note: You can also use the corporate bond yield of India in 1962 and current yield to normalize the equation for valuing Indian stocks. In such case, the value 4.4. will be replaced by the Indian corporate bond yield in 1962 and Y will be the current corporate bond yield in India. Make sure to use the correct values.
Note: The Adjusted Graham formula for conservative investors.
Many conservative investors have even modified the Graham formula further to reach a defensive intrinsic value of the stocks.
For example, Graham originally used 8.5 as the PE of the company with zero growth. However, many investors use this zero growth PE between 7 to 9, depending on the industry they are investigating and their own approach.
Further, Graham used a growth multiple of ‘2’ in his original equation. However, many investors argue that during Graham’s time, there were not many companies with a high growth rate, such as technology stocks which may grow at 15-25% per annum. Here, if you multiply this growth rate with a factor of ‘2’, the calculated intrinsic value can be quite aggressive. And hence, many investors use a factor of 1 or 1.5 for the growth rate multiple in their calculations.
Overall, the adjusted formula of conservative investors turns out to be:
V* = EPS x (7 + g) * (4.4/Y)
3. Pros and cons of Graham formula.
The biggest pros of Graham’s formula is its ease and straightforwardness. You do not require any difficult input or complex calculations to find the intrinsic value of a company using the Graham formula. In a few easy calculation steps, this method can help the investors to define the upper range of their purchase price in any stock.
However, as no valuation method is perfect, there are also a few cons of Graham formula. For example, one of the important inputs of Graham formula is EPS. Anyways, EPS can be manipulated a little by the companies using the different loopholes in the accounting principles, and it such scenarios the calculated intrinsic value might be misleading.
Another problem with Graham formula is that like most valuation methods, this formula also completely ignores the qualitative characteristics of a company like Industry characteristics, management quality, competitive advantage (moat) etc while calculating the true value of stocks.
4. Real life example of valuing stocks from Indian stock market using graham formula.
Now that you understood the basics of how you can value stocks using graham formula, let us use this formula to perform a basic stock valuation of a real-life example from the Indian stock market.
Here, we are taking the case study of HERO MOTOCORP (NSE: HEROMOTOCO) to find its true intrinsic value using the Graham formula. For Hero Motocorp,
EPS (TTM) = Rs 186.29
Expected growth (for the next 5 years) = 9.89%
(Past 5-year EPS growth rate per annum (CAGR) of Hero motocorp is 14.14%. Taking 30% safety on this growth rate as it is a large cap, we can estimate a conservative expected future growth rate of 9.89% for next few years).
Now first, let us find the intrinsic value of Hero motocorp using the original Graham formula,
V* = EPS x (8.5 + 2g) = 186.29 x (8.5 + 2*9.89) = Rs 5268. 28
Now, using the revised formula with conservative zero-growth PE of 7 and growth multiple of one, the intrinsic value of Hero motocorp turns out to be:
V* = EPS x (7 + g) x (4.4/4.22) = 186.29 x ( 7 + 9.89) x (4.4/4.22) =3280.65
At the time of writing this post, hero motocorp stock is trading at a market price of Rs 2961.90 and PE (TTM) of 15.90. Therefore, by using Graham formula, we can consider this stock to be currently undervalued.
Disclaimer: The case study used above is just for educational purpose and should not be considered as a stock advisory. Please research the company carefully before investing. After all, no one cares more about your money than you do.
You can also use Trade Brains’ online GRAHAM CALCULATOR to perform your calculations fast.
5. Closing thoughts.
An important point worth mentioned here is the concept of margin of safety that Benjamin Graham repeatedly taught in his books.
In simple words, according to the concept of margin of safety, if the calculated intrinsic price of a company turns out to be Rs 100, always give your calculations a little safety and purchase the stock at a 15-25% below that calculated value, i.e. when the stock trades below Rs 75-85.
Overall, Graham formula is a fast, simple and straightforward method to find the intrinsic value of stocks. If you haven’t tried it yet, you should definitely use this valuation approach while performing the fundamental analysis of any stock.
Investing for Beginners
If you are new to investing, you can learn how to perform stock valuation and pick profitable shares for consistent returns in the Indian stock market with Trade Brains flagship course ‘How to pick winning stocks’. It is a self-paced online course with lifetime access so that you can learn on your own schedule. This course is currently available at a discount. Check out more here. Happy investing!!!
Additional credits: Vasanth (for data inputs in Graham Formula)
3 simple tricks to stock research in India for beginners: Hi Investors. It’s been a while since I have written a blog post. This is because I’ve been working on a new project.
Since launching this blog ‘Trade Brains’ in January 2017, I have received a tremendous amount of emails, messages, and calls concerning stock market investment. Most of my readers are facing a similar problem- how to pick a stock to invest from a pile of over 5,500 stocks listed in the Indian stock market.
Though I have helped most of my readers, who have asked this question; however answering the same question, again and again, is little tiresome and mundane. Further, as this is a big topic, it took lots of hours to explain the same to every individual.
That’s why I created this video course on how to select stocks to invest in Indian stock market. Earlier I decided to include this post- ‘3 simple tricks to stock research in India’ in my course module. However, I felt that this content deserves to be publicly available on my blog as it can be quite helpful to the beginners to start stock research in India.
In this post, I will show how you can research good stocks in India to invest in using three simple implementable tricks. So, let’s get started.
3 Simple Tricks to Stock Research in India
1. Money control- Index composition.
If you want to investigate the stocks in a given industry/sector, why not to start with the market index composition of that sector.
An index composition of an industry consists of all the top companies that are included in that index.
For example, if you want to invest in a company in the metal industry, you should first start by investigating the stocks in the market index- S&P BSE Metal or Nifty Metal. Here S&P BSE Metal consists of companies like Hind Zinc, Coal India, Hindalco, Jindal Steel, JSW Steel, NALCO, SAIL, etc.
The index composition will give you a list of companies that you can investigate further in the industry.
Now, there’s a simple way to find out about the index composition of the different industries (Capital Goods, FMCG, Healthcare, Banks, Auto, Energy etc).
Either you can search for ‘money control index composition’ on google and click on the first link.
This will open the money control index composition page.
Or, you can directly visit the index composition linked here.
On the same page, you can navigate through different industries to know their composition.
Further, you can find the same information on NSE India website.
Here are the steps to find the index composition on NSE India:
Screener.in is a stock analysis and screening tool to see information of listed Indian companies in a customizable way.
This is one of the best websites for stock research in India. Screener gives you the facility to screen various stocks based on different criteria like growth, dividend, PE etc.
You can find the list of stocks based on different screens like- ‘The Bull Cartel’, ‘Growth Stocks’, ‘Loss to Profit Companies’, ‘Undervalued growth stocks’, ‘highest dividend yield share’, ‘bluest of the blue chips’ etc.
How to use screener website for stock research in India?
Investing in Bad News: Is it Worth Being Contrarian?
“To succeed as a contrarian you must recognize what the crowd believes, have concrete justification for why the majority is wrong, and have the patience and conviction to stick with what is, by definition, an unpopular bet.” -Whitney Tilson
Hello Readers. Contrarian investing in one popular strategy which has definitely build wealth for all those who have followed this strategy strictly. However, being a contrarian is easier said than done.
For today’s article, we will be exploring the strategy of investing in bad news, which also happens to be a common investing strategy used by most retail investors when dabbling in the stock markets.
The topics we shall be exploring today are as follows:
What is bad news investing?
Can bad news investing go wrong? If so, how?
A thinking model for investing during bad news
It’s going to be a very interesting article, especially in the dynamic market scenarios like that of late. Therefore, make sure that you read the article till the end so that you do not miss out any important concept. Let’s get started.
1. What is bad news investing?
Bad new investing is a simple strategy followed by investing across experience level where they buy stocks of companies that have been beaten down by negative sentiment in the media.
Most investors buy such companies when they believe that the news surrounding the company is only temporary in nature and the company can resume its past stock levels in time.
This is a strategy that was espoused by Benjamin Graham and has been followed by many of the great investors ever since including Warren Buffett, Peter Lynch, Carl Icahn, Mohnish Pabrai among others.
2. Can Bad News investing go wrong? If so, how?
Like all investing strategies, this one too is not without flaws. The strategy if not employed properly can result in losses or worse in permanent loss of capital.
Although it takes courage to go against the herd and a lot of the times it pays handsomely to do so. But, when deciding to invest in a stock surrounded by negative sentiment, it is important to realize that sometimes the stock would have fallen in price because it deserved to be priced lower.
A lot of times investors (including myself) tend to anchor to the price a stock was trading prior to the emergence of the bad news that price that is available at a significant discount to that price may seem to a buying opportunity (Also read- Value Traps).
A lot of times we tend not to redo our homework and perform the valuation for the company factoring in the effect of the news that has emerged instead we buy the stock based on the valuation we may have performed months before to make a buying decision.
3. Cockroach theory, Murphy’s law, and probabilistic thinking
Learning from my experience, a conservative investor would do well to keep these two thumb rules in mind when analyzing investment opportunities arising out of bad news.
The Cockroach Theory is a market theory that states that when a bad news is revealed about a company there is usually many more around the corner. This comes from the common belief that when a cockroach is spotted in a household, it is likely that there are many more in the vicinity.
Murphy’s law is pretty simple and straightforward compared to the former, it posits that whatever can go wrong, will go wrong.
Since investing is an imperfect art and it is impossible to state anything with certainty, investors would do well to think probabilistically to ascertain possibilities of thing going more wrong with the company.
For example, If a company’s management has been accused of fraud, then in all likelihood it is possible that the fraud has been happening for years and not a one-time thing.
On the other hand a factory being shut down due to worker protests could be a major event but the probability of such events impacting a major manufacturing company for the long term is pretty low since managers usually try to solve such issues by entering into contractual agreements with trade unions on new terms of operations and not just a non-written understanding of sorts.
4. A thinking model for investing during bad news
Many a time Warren Buffett has made an compared his investing style to Ted William’s baseball style in ‘The Science of Hitting’. Ted, famously proclaimed that he would wait for a fat pitch before attempting to hit a shot and ignore everything else.
We believe this concept is best explained in his own words, kindly refer to the excerpt below
Now building on his concept, let’s try to develop a map of bad news pitches we would receive as an investor.
From a logical perspective, the bad news could be of two types – it could be a temporary or a permanent problem while the impact this could have on the price could be large or small.
Taking different combinations of these would give us four possibilities as shown in the graphic below.
The sweet spot for us as investors would be to hit only those pitches that come at us from quadrant one since this is likely to be the situation where the market has overreacted to a minor news and has subsequently mispriced the underlying stock.
An investor could then proceed to add the stock into their portfolio all the while averaging down if the price of the stock were to drop below the initial entry price.
New to stocks? Here is an amazing online course for the beginners- How to pick winning stocks? Enroll now and start your journey in the exciting world of the stock market today!!
Although Bad news could provide an amazing opportunity for investors to add stocks to their portfolios, it can cause an equally potent damage to the portfolio in the event the buying decision turns out to be a bad one. It is therefore imperative for every investor to take time to think about the new realities the company is faced with before buying its stock.
We believe a prudent investor using a well defined rational process to invest in these situations should be rewarded handsomely over time. Happy Investing…!!
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.
What is working capital?
Why is working capital important?
What factors affect the working capital of a company?
When Negative net working capital is actually positive.
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
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
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!
Muhurat Trading 2018: First of all, a very happy and prosperous Diwali to you and your family. May this Diwali and the upcoming new years fulfills all the wishes that you wished for. Have a blast!
You might be ready for the Diwali; cleaned your house; bought diyas, candles, sweets & crackers etc. But are you ready for trading this Diwali?
Don’t be confused. Yes, the stock market will remain closed on Diwali, i.e. 7th November 2018, for the day. However, stock exchanges will open for an hour in the evening for trading.
This period of trading called ‘Muhurat Trading’ and this tradition has been followed in India since 1979. The mahurat trading period is considered auspicious for the upcoming year.
BSE and NSE will organize Muhurat Trading session between 5.30 PM and 6.30PM on this Diwali, and the pre-opening session will start at 6.15pm. Hence a normal trading will be conducted between these 60 minutes.
Anyways, gender bias is nothing new. Throughout history, when jobs are seen as more important or are better paid, women are squeezed out. And similar to this one, there are multiple common biases that we can notice in our day to day life.
But, what actually is a bias? — According to Wikipedia,
“Bias is disproportionate weight in favor of or against one thing, person, or group compared with another, usually in a way considered to be unfair.”
In other words, it is an inclination or preference that influences judgment from being balanced. Biases lead to a tendency to lean in a certain direction, often to the detriment of an open mind.
Behavioral Biases in Investing:
Investors are also ordinary people and hence they are subjected to many biases which influence their investment decisions. Although it takes time to control the behavioral biases, however, knowing what are these biases and how they work — can help individuals to make rational decisions when they are susceptible to these situations.
In this post, we are going to discuss five common investing biases that even investor should know.
When a human mind is determined towards one particular behavior, it subconsciously rejects the pieces of evidence against it while confirming the ones that go in its favor. This is known as confirmation bias.
Psychologically speaking, an investor would be more inclined towards his pre-occupied information and knowledge about certain kinds of investing. While considering the pros and cons of a certain kind of investment, the buyer would most likely go with what he used to believe until now.
For example: Making an investment in Bitcoin is dangerous and pointless. If this is an investor’s pre-occupied notion then he would most likely not invest in bitcoins in future.
Gambler’s Fallacy is one such proof which states that a human mind often interprets the outcomes of a future event judging by its corresponding past events even if the two are completely independent of each other. It is inspired by the “failures of gamblers” due to their probabilistic illusions to make decisions in casino games.
Gambler’s Fallacy can be very well explained with the help of a basic example involving a coin. For future reference, let’s suppose that the coin is fair with both sides (heads & tails) having an equal probability of landing on top.
Suppose a coin is flipped 10 times and the result of each event was “Heads”. What would you bet for the next coin flip?
Now, if a human bet on the outcome of the 11th flip of the coin to be “Head” seeing the past events, then it can be considered a bias.
The above context does only imply a simple rule: The occurrence of an independent event is not dependent on past events. In this example, the 11th flip of a coin would result in both heads and tails with a 50% chance of being associated with each one of them.
The regret after purchasing a product is called a buyer’s remorse. Here, the buyers may regret that either they overpaid for the product or they didn’t actually need that product.
Nevertheless, purchasing commodities are not the only thing where people feel “buyer’s remorse”. Stock investors are also like ordinary people, and they too feel this remorse after purchasing equities.
“Was buying this stock a mistake?”
“Was my timing right?”
“Did I just buy a lemon of a stock?”
“Is the market going to collapse?”
“What if I lose money?”
In general, investors feel remorse when they make investment decisions that do not immediately produce results.
An investor’s natural instinct goes with the ones of masses, which means that he/she doesn’t seem to have a rational view on a certain investment but is more likely to deviate where the majority mass is moving — this little phenomenon is known as the “Herd Mentality”.
The term has been derived from the natural instinct of a number of sheep walking together in a herd so as to avoid falling into the pitfalls of danger.
Interestingly, you can also find a large population of investing community following herd mentality psychology in making various financial decisions like buying new property or investing in the stock market. Seeing others getting profited with an investment, our brain tells us to go for it without a second thought.
A bidder sitting in an auction and trying to repeatedly bid on an asset often gets intimidated to continue his bidding even if it is not profitable.
As obvious, in such scenarios, the last one to bid gets the asset and hence gets the title of “the winner”. But has he actually won? What do you think? The inference can be a bit deeper than you are assessing it to be.
Such scenarios are quite noticeable everywhere, including investing.
In the stock market, every now and then, you may come across a storyline where people are buying expensive stocks because they don’t wanna lose the opportunity. Here, they are ready to bid a huge price to win that stock. However, purchasing an overvalued stock (only for the sake of winning) is most of the time disadvantageous for the investors. Another example of winner’s curse is bidding in expensive IPOs.
Most biases are pre-programmed in the human nature and hence it might be a little difficult to notice them by the individuals. These biases can adversely affect your investment decisions and your ability to make profitable choices.
Anyways, knowing these biases can help you to avoid them causing any serious damage. Moreover, a good thing regarding these biases is that — like any habit, you can change or get over them by practice and efforts.
“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” -Benjamin Graham
Gambling is not restricted to just casinos or horse racing. In fact, a majority of investing population either speculate or gambles in stocks. However, similar to casinos where the odds are always in favor of house over the long run, gambling in the stock market also have similar results.
While investing in stocks, you should always remember that your returns should be commensurate with the risks that you are taking. If the risks are too high compared to the safety and returns, you are not investing, instead speculating or gambling. A quick note, gambling is not the same as speculating. Gambling is speculating taken to an extreme.
The problem with too many people is that they believe that they are investing in stocks, but in actual they are speculating or gambling.
A typical example of gambling in stocks is people trying to make short profits from the minute market movements by trying to perfectly time the market. Unless you are trained to do so (like technical analysts), it is really difficult for the average investors to time the market precisely and repeatedly.
In this post, we are going to discuss five signs that may prove that you are gambling in stocks.
5 Signs That You are Gambling in Stocks.
1. Taking Free tips/recommendations:
If you are serious about investing in stocks and making money, either devote your time and learn the fundamentals or take the help of registered/certified investment advisors. Investing based on the hot tips or recommendations that you heard on a tv channel or from a colleague is a definite route to lose money. Most of the people who make consistent money from stocks are either do-it-yourself (DIY) investors or the ones who are smart enough to take the help of registered investment advisors. Yes, the advisors will charge you some fee. But consider it as the charge of calculated risk over the un-calculated ones.
2. Betting big money on short-term twitches in market
Investing big money on the hot news that just read on the news website definitely doesn’t come in the category of investing. The future return from stocks is based on many factors which should be carefully studied rather than investing based on single news of a quarterly jump of EPS of a company by 40% or launch of a new hyped product. Serious investors should perform detailed qualitative and quantitative study rather than investing based on short-term market twitches.
Always remember the famous quote by Benjamin Graham- “In the short run, a market is a voting machine, but in the long run it is a weighing machine.”
It simply means that market phonology is hard to predict in short-term as sentiments drive it (similar to voting machine). On the other hand, long-term results can be measured precisely and concretely, if the studies are done correctly (like weighing machine). Focus on the long-term performance of the stocks, rather than short-term turbulence.
Betting all your money in a single stock is the worst form of gambling in stocks. Maybe it seems a great opportunity now. However, there can be thousands of reasons which may prevent the stock from performing. And if that stock doesn’t perform as you wished, for whatever reason, all your hard earned money will be gone. Putting all in a single stock magnifies the risk. The wise approach for intelligent investors is to diversify their portfolio. As the old ones used to say- “Do not put all your eggs in one basket.”
4. Using your emergency fund for short-term trades
An investor should understand the risk and reward. Investing your emergency fund to make short-term trades is a definite sign of gambling. After all, no matter how safe is the trade, you cannot predict the outcomes. If things go wrong, you won’t have any alternatives if you have already used your emergency fund. As a thumb rule, always invest the money that is surplus.
5. Investing based on what big investors are purchasing
It’s challenging to understand the exact strategy of the big players of the market, no matter how carefully you track their investments. Moreover, a regular investor cannot match the resources available to big investors. Investing blindly in what big players are purchasing is undoubtedly a sign of gambling in stocks.
Another way to find if you’re gambling in stocks is by figuring out how much emotionally involved you are. If you’re stuck with your phone/laptop screen throughout the trading hours, checking the stock price continuously, then you might be speculating. Moreover, if your investments are keeping you up all night, then you might be taking too much risk.
Anyways, speculation and gambling are not inherently wrong. Both have their own pleasures, benefits and a role in the financial world. The problem arises which people gamble in stocks and believes that it is a perfect investment. In such scenarios, people don’t know how much risk they are taking and whether those bets are even worth taking financially.
Can you build a long-term portfolio successfully with the help of short-term trading plans? Are you hedging it right?
Everyone knows that India, currently, is one of the finest markets to invest in. The major reasons being the current as well as forecasted economic developments, high returns on investment, increasing consumption pattern, growth prospects, political scenario and outlook, budget deficit and proposed infrastructural plans/projects. The long-term journey of India Inc. looks healthy, rewarding, and in good shape.
However, there are a couple of questions which come in the mind of every investor:
How long is long term?
What is the right time to enter the market?
The first question is correctly valid considering the changing business models, dynamic technological progressions etc. There are many business models which may become obsolete in a few years. Only a handful of companies, which can adapt to the dynamic environment, will survive.
Not to forget, As of 2018, only 7 companies are still part of the original Sensex 30 which was formed in the year 1987.
This entire critique revolves around the discussion for the second question. There are various macro factors affecting the overall market sentiment including market cycles of different time frames, economic cycles, political outlook and last but not the least, company’s stage of growth and development and its responses to the dynamic environment that needs to be considered while entering the capital market for a longer period of time. The most important thing to remember is one should invest in a business as against investing in a company.
Are investors capable of avoiding the short-term movements in the prices of the company’s stock? How does the investor’s mindset change in the bearish market? How can one capitalize such market scenario as well? How to maintain the balance between greed and fear? Can any investor actually time the market? What are the alternatives to be actively present in the market but not getting affected by the market dynamism?
Since the Indian equity markets made the record highs in the calendar year 2017 and 2018, each and every investor must have been waiting for the right entry point. Be it either by way of fresh investments (first entry in the capital markets) or by adding up to their existing portfolio. No one wants to enter the markets when they are just about the consolidate.
With the recent consolidation in the markets and their sideways movement, the fear of a consolidation phase continuing for the rest of the year in the Indian equity markets might be just around the corner for all investors. Although most of the Marquee investors, foreign financial institutions as well as the domestic Institutional Investors are very bullish on the Indian economy in the long run, they are contemplating a phase of consolidation in the year 2018.
One of the marquee investors, Rakesh Jhunjhunwala, even said that the incredible gains marked in the Indian capital markets in the year 2017 are bound to be abridged by some level of profit booking that could be seen in the calendar year 2018. After yielding stellar returns in the year 2017, everyone is expecting the markets to consolidate till the time the quarterly earnings increase to a level that could substantiate and corroborate the current price levels and high P/E multiples.
Here are some of the questions that we get to hear a lot from many of the investors;
How to survive a falling / bearish market?
Can investor do anything about their existing exposure to capital markets when the market sentiments are negative, prices in the forex market are volatile and the share prices are all set to nosedive?
Will the recent default by the IF&FS group lead to a financial crash in India or is this just another case of a group that is Too Big to fail?
How can an investor with an ‘All long equity’ mindset survive in the midst of rising capital market chaos, unveiling flaws with company’s management, high level of volatility and rising political turmoil?
What should the investors do to their existing investment strategy and asset allocation? Should the investors look for a short-term shift from capital markets?
With the likes of Yes Bank, DHFL and other NBFCs plummeting down to unexpected levels, is there something more to come?
The auto sector companies are offering huge discounts to increase the volumes but still failing to meet the street expectations with the quarterly results and the monthly auto numbers. What should be the investor’s bet for this festive season?
With the dollar appreciating against rupee and the rise in the oil prices, what can be expected from India Inc.?
Innumerable questions are on top of the mind of every investor succinct to one broad question –
What are the change/adjustments required in the trading / investing strategy of every investor in order to capitalize opportunities in the bearish market?
To summarize this, each investor is worried about their existing exposure to the capital markets fearing what can come up next to their stocks.
The alternatives available to all the ‘All Long Equity Investors’ are;
The investor will have to sit on cash i.e. exit the existing portfolio; or
Be in the market, earn negative returns on the stock portfolio and wait for the right time to average the holdings until the market has bottomed out.
More than 9 months have passed in the year 2018 and we have seen a steep correction of up to 55 percent in small and mid-cap shares and up to 30-35 percent in some of the large-cap stocks as well. In fact, the broad market index – Nifty has also corrected in a double-digit percentage from the record high made in the year 2018 itself.
After all these discussions as well, there are institutions that are still making money. In a falling market, an investor can make money only by short selling i.e. sell at a higher value first and cover the position by buying the equivalent quantity at a lower price. However, equity markets (cash segment) do not allow the investors/traders to carry forward such a trade to the next day. i.e. the investor will have to square off (buy it again) the open sold position on the same day i.e. Intraday trade only. This is also known as entering a bearish trade. An alternative is to trade in options.
In a scenario where there are no clear opportunities/ideas for investing in specific stocks and earn money from equity markets (cash segment) as well as there are constraints of capital for investing into equities to average the cost of stocks, the investor should look to move to option trading.
The next question that comes to the minds of the investors is that with the constraint of capital, time and resources, how can an individual investor go on to take the additional risks of trading in option.
Options trading, if done with proper analysis and the right approach, are the safest bets that could yield the highest returns. Options trading is just perceived to be risky. Options are very powerful to enhance an investor’s portfolio returns. Option, if used wisely, can prove to be a perfect hedge to the existing exposure to the capital markets.
A popular example would be using options as an effective hedge against a declining stock market to limit downside losses. Options can also be used to generate recurring income (option writing, explained later in this article).
In the Indian derivatives segment, there are two main types of options – Call and Put. In case of strong bullish view on any stock, the trader may go for long-call option i.e. Buy call option. As against this, in case of strong bearish opinion for any stock, the trader may go for a long-put option i.e. Buy put option. Selling call options and put options trades are executed in case of week bearish or bullish interpretation respectively, on the movement of the stocks and it is primarily dealt to earn the share of premium and capitalize time value of money (Option writing, explained later in this article).
As explained, there are four coordinates to option trading – Long call, Short call, Long put and Short put.
Buying a stock gives you a long position. Buying a call option gives you a potential long position in the underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered call gives you a potential short position in the underlying stock
People who buy options are called holders and those who sell options are called writers of options.
A basic call option, in its meekest explanation, can be thought of as a down payment / token money paid for purchasing a house property in future.
For example: Whenever an investor decides to purchase a house property, he sees a new development going up. That person may want the right to purchase the house property in the future but will only want to exercise that right once those prophesied developments (let’s say, upcoming infrastructure road development project has been substantially finalized or a school has been built) around that area are built. These circumstances would affect the investor’s decision to purchase the house property. The potential investor would benefit from the option of buying or not (basis such developments). Imagine they can buy a call option from the developer to buy the home at say INR 10 lakhs at any point in the next three years. Naturally, the developer wouldn’t grant such an option for free. Such a payment is a non-refundable deposit. The total cost of purchase of the house property is INR 200 lakhs.
The investor needs to make that down-payment to lock in the right to purchase the house property at a future date within a stipulated time of three years.
Connecting the above example with the derivative markets, the down-payment no refundable deposit cost is known as the Premium. It is the price of the option contract paid by the investor to acquire the right to purchase at a future date. The investor is said to have gone long the call option. The total cost of the house property fixed between the investor and developer of INR 200 lakhs is the contract price of the option contract. It means that irrespective of the market conditions, the investor has the right to purchase the house property within a period of 3 years at a fixed price of INR 200 lakhs.
Let’s say, two years have passed, and now the developments are in line with the proposed plans of the area and zoning has been approved. There is no garbage dump that is coming nearby; School and road projects, as forecasted, are up and running. The investor exercises the option and buys the home for INR 200 lakhs, as agreed earlier. The market value of that home may have increased multi-fold times to, let’s say, INR 600 lakhs because of all the developments in that area. Nonetheless, the investor has the right to purchase the house property a pre-determined price locked in at INR 200 lakhs only.
Since the value of the underlying asset increased, the call option buyer benefited from the transaction.
Now, in an alternate scenario, say the zoning approval doesn’t come through until year four or the school which was proposed to be constructed, did not come through, and the market price of the house property falls to INR 100 lakhs. The investor will not want to exercise his right to purchase the house property since he is getting it at a much discounted price from the market. The down payment paid shall be, obviously, forfeited by the developer.
The main advantage of going long (bullish trade) with a call option is that the maximum loss shall be restricted to the amount of premium paid to enter into the contract keeping the potential upside of the profit open. To simplify, the investor can gain from the up-move of the stock without purchasing the stock. The huge capital required to purchase the stock is no longer required because the upfront cost is limited to the amount of premium.
Selling a call option (Short call)
The above example was the case when the investor purchases options i.e. get the right but no obligation to purchase the underlying asset. Let’s look on the other side of the coin. What happens when the individual sells options instead of buying? What are the rights and obligation of the other party to the contract?
This phenomenon is called option writing (option selling). In such a case, the option writer will have the obligation to deliver the underlying asset on the date of expiry of the contract, if the option buyer exercises the right in the option contract.
Continuing the above example of making payment of the token money/down payment to purchase the house property on a future date at a predetermined contract price. The developer who receives the token money is known as the option writer. He is obligated to sell the house property at a predetermined fixed rate of INR 200 lakhs (as per the contractual terms), irrespective of the actual market price of the house property at the time of exercising (after 3 years).
To summarize, if the home buyer does not exercise his right, the down payment (known as the premium) received shall be the income of the developer.
A put option can be thought of as an insurance policy against any asset. It is to protect the downside risk of the asset owned (securities). For example, the investor foresees a fall in the prices of the broad equity index of close to twenty percent in next six months because of the best reasons known to him. However, the investor does not want to liquidate its exposure in the equity markets because of the long-term positive outlook. To avoid the short-term losses because of the increased volatility, the investor can hedge its existing exposure to the equity markets by entering into a put options contract. A long-put option contract is a bearish trade which works like an insurance policy against the underlying asset. A long-put option gives the investor the right to sell the underlying asset at a predetermined price for a specific period as per the options contract.
Even if the value of his shares become zero, the investor can exercise his right to sell at a fixed price determined at the time of entering the options contract.
Needless to say, purchasing such a right to hedge the downside risk of the underlying asset has to come with a cost. This cost is known as the premium of the option. Similar to the long call option, the maximum loss on the long-put option contract is limited to the amount of premium paid to acquire the right to sell the underlying shares.
If there are investor hedging the downside risk of the underlying asset, there has to be someone who ensures such downside risk. With that, we come to the last co-ordinate of option trading i.e. writing put options. Continuing the above example of insurance contracts, the insurance companies which are receiving the amount of premium are known as put option writers. The put option writers are obligated to purchase the underlying asset in case the put option buyer exercises his right to sell the underlying asset.
This works exactly similar to call options where the maximum loss for the put option buyer is limited to the amount of premium paid as against the maximum loss for the option writers is limited to the total value of the underlying asset (the price of a stock can fall maximum till zero).
Now the real question which most of you might have;
Why would anyone opt for writing options as against buying options? Option writing has more risk and limited profits (limited to the amount of the premium received). As against this, option buying has a limited risk (limited to the amount of premium paid) and unlimited profits (the upside of the stock is unlimited)
The answer to this question is also very simple. How often do you see exercising an insurance policy within the stipulated time period? How are insurance companies surviving since their entire business revolves around offering safeguards against losses?
That’s correct, the major revenue stream for any insurance company is by way of the premium received. Most of the policyholders do not exercise the insurance contracts within the stipulated time frame and forgo the amount of premium.
The maximum liability of the insurance company is unlimited to the extent of the amount of loss. The maximum profit shall be the amount of premium. However, no one talks of the probability of winning as an option buyer. Option seller, on the other hand, is operating with a very high probability of winning (discussed later in the article).
To summarize, call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights. This limits the risk of buyers of options to only the premium spent.
Call writers and put writers (sellers), however, are obligated to buy or sell if the option expires in-the-money. This means that a seller may be required to make good on a promise to buy or sell. It also implies that option sellers have exposure to more and in some cases unlimited, risks (theoretically). This means writers can lose much more than the price of the options premium (again, theoretically).
How is the derivatives segment in the Indian capital markets different from the above examples, practically? Does the Indian capital markets offer a physical settlement of the underlying asset? Can the contracts be settled before the stipulated time period in the contract?
Theoretically, this is exactly how any option derivative would function in a hypothetical scenario. However, practically, the Indian capital markets do not offer a physical settlement of the underlying stocks. Instead, the contract is always cash settled i.e. the amount of benefit to the option buyers or option sellers derived from the underlying asset is reflected in the price fluctuations of the premium of that option contract.
Continuing the above example of the right to purchase the house property within three years, with every passing year and the development of that area, the cost of purchase of the house property will increase. Such benefit from the increase in the purchase cost of the house property will be reflected in the amount of premium to be paid to acquire the right to purchase after the stipulated number of years. Initially, the investor paid INR 10 lakhs to acquire the right in year 0. Post the developments, the premium might have increased to INR 30 lakhs in year 2 apprehending the increase in the total cost of purchase of the house property.
Practically, in the derivatives capital market, the investor can sell the premium at the end of year 2 at the market price and the difference will be the profit. This is known as Cash settlement of option contracts. Although the contracts are settled only on the expiry of the contracts, the parties to contract can square off their existing exposure to the option trades with other market players. The difference between the buying and selling price of the premium amounts will be the payoffs for the investor from that trade.
Now the next question that comes to every trader’s mind is that which strategy should be opted?
There are four co-ordinates to option trading having two possible views – bullish or bearish. For example; most of the option traders are confused between ‘selling a call option’ and ‘buying a put option’. Broadly both are bearish strategies. Buying a put option is preferred when the trader expects a weakness (steep fall within the stipulated contract period) in the stock. As against this, selling a call option is preferred when the trader expects no further upside for that stock. In a scenario when the stock is stable through the period of contract, the option seller still earns the amount of premium because of the element of time value in the option. Most option writers capitalize this time value premium in every option price. Option writing should be used as a hedging total as well as to reduce the total cost of buying the option.
In my opinion, option writers tend to earn more than option buying. Selling options, whether calls or puts is a popular trading technique to enhance the returns to the entire portfolio.
If the trades are executed with precision, proper analysis and patience, the trader definitely earns anywhere between 5 (on the minimum) to 25 percent month on month.
To support this view, reliance is placed on a study paper by Dr. John F. Summa which was published in 2003 in Futures Magazine. In his study, Dr. Summa finds that, regardless of the market direction and market sentiments, option sellers have an advantage over option buyers. Based on his study of expiring and exercising options covering a period of three years, an average of 76.5 percent of all the options held till expiration expired worthless (out of the money). The same has been tabulated as under;
On this general level of information about option trading, we can conclude that for every option exercised in the money, there were three options expired out of the money and thus worthless. Therefore, option sellers had better odds than option buyers for positions held till expiration. Even though the study paper was submitted 15 years ago, not much has changed in the context of capital markets except the price of the stocks.
In addition to these, the option buyer is said to operate with limited risk and an opportunity to gain unlimited reward. But no one talks of the probability of winning as an option buyer. Option seller, on the other hand, is operating with a very high probability of winning.
Further, in such a market where investors are fearful of investing more money to the markets and increase the exposure, an option seller can use collateral and need not bring in funds. Further, the seller has the flexibility of hedge his position using the same collateral. As against this, an option buyer has to bring in capital to buy the option.
Even though the statistics and probability backs option writing over option buying, it requires immense precision, diligent thinking, and meticulous monitoring.
To conclude, I would just like to quote PR Sundar’s words in one of his interviews, ‘Option selling is like sitting in front of a bonfire. If you are too close, you can get burnt. If you are sitting too far, then you will not enjoy the warmth. You need to sit at the right distance from the fire’.
Applying the analogy in option trading, If you are trading close to the market price, then the risks will be higher i.e. risk of the strike price so traded, being in the money at the time of expiration). If you are trading a strike price which is too far away from the current market price of the underlying asset, the reward (the amount of premium) will be low as will be the risk of that trade. It is the flexibility, hedging advantage and the probability of success that option trading offers that makes it a very attractive tool to indulge into.
Have a good day! Happy Investing! Happy Trading!
Note: This article is written by guest-author ‘Pranav Thakkar’ and also posted here.