equity valuation cover 2

Equity Valuation 101: Why Value?

A prominent question many people have about investing in stocks is, “Does the purchase price matter?” or “Should I value a stock before purchasing it”?

A lot of financial theory argues that you shouldn’t. They say, markets are always efficient in pricing securities and you should rather worry about decreasing frictional costs like brokerage charges, transaction charges, churn costs and so on.

But Mr. Charlie Munger, the business partner of the world’s richest investor Mr. Warren Buffett, has a different answer:

It was always clear to me that the stock market couldn’t be perfectly efficient, because, as a teenager, I’d been to the racetrack in Omaha where they had the pari-mutuel system. And it was quite obvious to me that if the ‘house take’, the croupier’s take, was seventeen percent, some people consistently lost a lot less than seventeen percent of all their bets, and other people consistently lost more than seventeen percent of all their bets. 

 

So the pari-mutuel system in Omaha had no perfect efficiency. And so I didn’t accept the argument that the stock market was always perfectly efficient in creating rational prices. The stock market is the same way – except that the house handle is so much lower.

 

If you take transaction costs – the spread between the bid and the ask plus the commissions – and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that, with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.

 

It is not a bit easy…But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking. To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.

Charlie Munger (USCB, 2003).

Interesting. So, what’s ‘Parimutuel Betting‘?

Let’s say that you are about to bet $100 on a Horse Race. A total of ten horses are participating in the race and you are given the following statistics:

You are told that 100 people have laid down their bets (Let’s call them the ‘Horse Market’) and the total pool of bets is $4,050. Indirectly, you can assess how these 100 people have determined the probability of winning, or ‘Odds’ of winning, for each of these horses. In fact, Horse #6 seems to be an overwhelming favorite, with $1,700 bet for the horse.

But before blindly betting on Horse #6, you need to understand the most important thing about Parimutuel Betting. If Horse #6 indeed wins, everyone who bet on Horse #6 will get $4,050 i.e. Everyone will make roughly 2 times of their bet amount (For convenience, let’s just say the remaining 0.38 times is participation fee). Is that good?

Hold your horses (Pun intended)!

If you bet on Horse #5 or Horse #9 instead, you can make 81 times the money, instead of the paltry 2 times. Well, well, now is this a better bet? Logically speaking, these horses have had a very little bet on them because they may be poor to begin with. The 100 gamblers already know this. That’s why only 1-2 of them have placed bets for these horses.

Wait, this is confusing. Which horse should I bet on now? Let’s recount the statement made by Mr. Charlie Munger:

“We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble.”

A mispriced gamble. That’s where the trick lies. To summarize Mr. Munger’s thought process:

  1. You shouldn’t bet blindly on Horse #6, because you will only make only 2 times the money, the lowest reward of the lot. Even when Horse #6 can be deemed the healthiest horse with the most skilled jockey, the payout is simply too low.
  2. You shouldn’t bet blindly on Horses #5 or #9, even though they have an astronomical payout of 81 times. It is more likely that Horses #5 or #9 could be sick/weak or their jockeys inexperienced.
  3. The sweet spot, therefore, is in a bet where you think there’s mispricing i.e. A bet where the ‘Odds’ have been miscalculated by the Horse Market people. Take Horse #1 for instance. The Odds here are 8:1 i.e. The Horse Market people think there’s only a 12.50% (1/8) Probability of this horse winning. If you believe that these Odds are somehow way wrong i.e. If you believe that this horse actually has a 25% (1/4) Probability of winning, then you should consider betting on this one. Of course, you should repeat this exercise for all the horses and figure out which one has the most mispriced Odds and bet on that one.

Sounds simple enough? Horse Betting is decidedly more complex than this. However, it proves to be an interesting lesson in investing. This system of Parimutuel Betting, Mr. Munger argues, also applies to the Stock Market. I would personally visualize it like this:

To put it in a words, then:

  1. You shouldn’t invest blindly in the well-known, excellent company. Although these type of companies have the lowest probability of making a Capital Loss (i.e. Chance of not achieving the Average Returns) over the long term, they also have a low, 15% returns over the long term. Put together, they have an Expected Returns of 12%, which is neither too high, nor too low.
  2. You shouldn’t invest blindly in the unknown, terrible company. Although these type of companies can become potential ‘multi-baggers’ over the long term, clocking a CAGR of 23%, they also come with a high 50% risk of a potential Capital Loss. Put together, they have an Expected Returns of 11.50%, the lowest of the lot.
  3. The sweet spot, therefore, could be in the lesser-known, mediocre companies. These type of companies offer a decent 18% CAGR over the long term and also come with a moderate, 30% Capital Loss probability. Put together, they have an Expected Returns of 12.60%, the highest of the lot.

Of course, this is just an example. There are thousands of Stocks listed around the world and there might very well be numerous permutations and combinations of this in action at any given time. Instead of the 100 people from our horse betting example, the Stock Market consists of millions of people. They are pricing the odds for a stock every moment a trade is executed. It is an investor’s job to figure out the most mispriced bet and pick it up.

Just remember. You don’t make the most money-per-risk-taken by betting on the most favorite gamble. And you don’t make the most money-per-risk-taken by betting on the least favorite gamble, either. You make the most money-per-risk-taken by betting on the gamble where the odds are highly mispriced.

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

That’s it for today! I’ve used the word ‘Intrinsic Value’ several times in this post, without really letting on much what it is supposed to be. Think about what it means. Let’s explore this more in ‘Equity Valuation 102’, the next post.

sebi securites and exchange board of india

What is SEBI? And What is its role in Financial Market?

The capital market started emerging as a new sensation in India during the end of the 1970s. However, with the popularity of stocks, a number of malpractices also started rising like price rigging, unofficial private placements, non-compliance with the provisions of the Companies Act, insider trading, violation of stock exchange rules and regulations, delay in making delivery of shares and many others.

As this time, the Indian Government realized the need for establishing an authority to reduce these malpractices and regulate the working of the Indian securities market as the majority of Indian People started losing their trust in the stock market.

Soon after, SEBI (Securities and Exchange Board of India) was set up in the year 1988.

Initially, SEBI acted as a watchdog and lacked the authority of controlling and regulating the affairs of the Indian capital market. Nonetheless, in the year 1992, it got the statutory status and became an autonomous body to control the activities of the entire stock market of the country.  The statutory status of the SEBI authorized it to conduct the following activities:-

  1. SEBI got the power of regulating and approving the by-laws of stock exchanges.
  2. It could inspect the accounting books of the recognized stock exchanges in the country. It could also call for periodical returns from such stock exchanges.
  3. SEBI became empowered to inspect the books and records of financial Intermediaries.
  4. It could constrain companies for getting listed on any stock exchange.
  5. It could also handle the registration of stockbrokers.

SEBI is headquartered in Mumbai and having its regional offices in New Delhi, Chennai, Kolkata, and Ahmedabad. You can also find SEBI’s local offices in Jaipur, Guwahati, Bangalore, Patna, Bhubaneswar, Chandigarh, and Kochi.

At present, 17 stock exchanges are currently operating in India, including NSE and BSE. The operations of all these stock exchanges are regulated by the guidelines of SEBI.

The organizational structure of SEBI

Mr. Ajay Tyagi is the current chairman of SEBI. He was appointed on the 10th of January, 2017 and took over the charge with effect from 1st March 2017 from Mr. U.K. Sinha.

SEBI consists of one chairman and other board members. The honorable chairman is nominated by the Central Government. Out of the eight board members, two members are nominated by the Union Finance Ministry and one member is nominated by the RBI. The rest five members of the board are nominated by the Union Government.

The objectives of SEBI

SEBI’s responsibility is to ensure that the securities market in India functions in an orderly manner. It is made to protect the interests of investors and traders in the Indian stock market by providing a healthy environment in securities and to promote the development of, and to regulate the equity market.

Further, as stated earlier, one of the prime reason for establishing SEBI was to prevent malpractices in the Indian capital market.

SEBI’s main roles in the Indian financial market

In order to achieve its objectives, SEBI takes care of the three most important financial market participants.

— Issuer of securities. These are the companies listed in the stock exchange which raise funds through the issue of shares. SEBI ensures that the issue of IPOs and FPOs can take place in a transparent and healthy way.

— Players in the capital market i.e. the traders and investor. The capital markets are functioning only because the traders exist. SEBI is responsible for ensuring that the investors don’t become victims of any stock market manipulation or fraud.

— Financial Intermediaries. They act as mediators in the securities market and ensure that the stock market transactions take place in a smooth and secure manner. SEBI monitors the activities of the stock market intermediaries like brokers and sub-brokers.

The functions of SEBI

The SEBI carries out the following three key functions to perform its roles.

1. Protective Functions: SEBI performs these functions for protecting the interests of the investors and financial institutions. Protective functions include checking price rigging, prevention of insider trading, promoting fair practices, creating awareness among investors and prohibition of fraudulent and unfair trade practices.

2. Regulatory Functions: Through regulatory functions, SEBI monitors the functioning of the financial market intermediaries. It designs the guidelines and code of conduct for financial intermediaries and regulates mergers, amalgamations, and takeovers takeover of companies.

SEBI also conducts inquiries and audit of stock exchanges. It acts as a registrar for the brokers, sub-brokers, merchant bankers and many others. SEBI has the power to levy fees on the capital market participants. Apart from controlling the intermediaries, SEBI also regulates the credit rating agencies.

3. Development Functions: Among the list of SEBI’s development functions, one of them is imparting training to intermediaries. SEBI promotes fair trading and malpractices reduction. It also educates and makes investors aware of the stock market by utilizing the funds available in IEPF.

Conclusion

The stock market is one of the most crucial indicators of a country’s economic health. If people lose faith in the market, the number of participants will go down. Furthermore, the country will also start losing FDIs and FIIs considerably which will substantially hamper the country’s foreign exchange inflows.

Before SEBI was established many scams and malpractices took place in the Indian stock market. One of the famous Indian stock market scams was “Harshad Mehta scam.”

After SEBI came into power, stock market affairs started becoming healthier and more transparent. Nonetheless, some securities mark scams have taken place even after SEBI came into power. One famous such scam was “Ketan Parekh scam

Although unfair activities do happen in the Indian capital market even as of today, their frequency is quite less. Moreover, the security market statutes and regulations are updated time and again. Therefore, day by day, SEBI is getting more and more stringent with its authority.

The Dogs of the Dow Strategy For Picking Stocks cover

The Dogs of the Dow Strategy For Picking Stocks

The Dow Jones Industrial Average (DJIA) or the Dow is an index of 30 companies that many investors are confident about investing in. It shows the market valuation of companies such as General Electric, Exxon Mobil and Microsoft Corporation and is a good reflection of how the markets are performing. A common strategy used by traders when investing in the Dow is the ‘Dogs of the Dow’ strategy.

This strategy involves a trader buying the top 10 stocks with the highest yield from a bucket of 30 stocks in the Dow. The idea behind this strategy is that blue-chip stocks with a high dividend yield is a sign that these companies are currently facing a downturn in their business cycle and in the upcoming year these values are sure to increase as the company goes through its cycle.

What is the DJIA?

The DJIA or the Dow is one of the most famous and trusted indices in the world. Founded by Charles Dow during the 19th century, the DJIA assesses the value of a basket of 30 blue chip companies based in the United States. Blue-chip stocks are shares of large, well-recognized companies that have a high valuation and a long history of trading on the stock market.

Here are the 30 stocks that make up the Dow Jones Industrial Average as of today.

Company Price (USD)
MMM 3M 207.39
AXP American Express 107.74
AAPL Apple 173.15
BA Boeing 439.96
CAT Caterpillar 137.34
CVX Chevron 119.58
CSCO Cisco 51.77
KO Coca-Cola 45.34
DIS Disney 112.84
DWDP DowDuPont Inc 53.23
XOM Exxon Mobil 79.03
GS Goldman Sachs 196.7
HD Home Depot 185.14
IBM IBM 138.13
INTC Intel 52.96
JNJ Johnson & Johnson 136.64
JPM JPMorgan Chase 104.36
MCD McDonald’s 183.84
MRK Merck 81.29
MSFT Microsoft 112.03
NKE Nike 85.51
PFE Pfizer 43.35
PG Procter & Gamble 98.55
TRV Travelers Companies Inc 132.91
UTX United Technologies 125.67
UNH UnitedHealth 242.22
VZ Verizon 56.92
V Visa 148.12
WMT Wal-Mart 98.99
WBA Walgreen 71.19

Usually, when people say ‘the market is doing well’, they are most likely referring to the DJIA. The index also provides valuations for certain industries such as the Dow Jones Utility Average and the Dow Jones Transportation Average. Other famous indices like the DJIA include the S&P500 index which is an index that values 500 companies.

Also read: What are FANG stocks? And why are they so popular?

How is the DJIA calculated?

The DJIA calculates the value of 30 blue chip companies whose valuations have a large influence on the economy and are a good reflection of the current market conditions. The companies that are to be included in the DJIA are selected by editors of The Wall Street Journal.

When valuing the companies, the Dow only considers the average price of the stock and not the company’s market capitalization. Hence if both company A and B have a stock price of $40 but their market capitalizations are $30 million and $90 million respectively, as per the index calculation both companies will have the same impact on the market and the movement of the DJIA.

But the DJIA index differentiates between stock splits, spin-offs etc using a divisor. Before the divisor, the total value of the stock prices was divided by the total number of stocks. However, if there was a stock split in one of the shares, dividing it by the total number of shares will not provide an accurate value of the DJIA.

With the divisor, the value of the stock will be calculated as follows:

Say a stock has a share price of $50 that is split into two and the total sum of all the 30 stocks in the bucket is $1096. The first step will be to subtract the split stock from the total: 1096-25= $1,071.

To find the new divisor after the stock split you need the new sum by the index value before the split. Therefore: [1071/(1096/30)]= $29.32 (new divisor)

The new DJIA= 1071/29.32= $36.53

Why is the Dogs of the Dow strategy great for investors?

Using the calculation shown above the DJIA provides the valuation of 30 large companies that have a high market valuation and provide an accurate reflection of the market conditions. The Dogs of Dow strategy, introduced by Michael B. O’Higgins in his book Beating the Dow, picks the top 10 companies out of the 30 included in the index based on their dividend yield. The Dogs of the Dow are a list of the current 10 companies ranked by their yield in the prior year from highest to lowest. The dividend yield is the ratio of the total dividends paid out to shareholders to the market value of its shares. Therefore companies with a high dividend yield pay out a large amount of their revenue in the form of dividends.

The Dogs of Dow is an optimal strategy for many investors as it ensures that they receive a high return on their investments. Many investors usually pick stocks based on the number of dividends they receive and buying the stocks with the highest dividend yield (10 Dogs of the Dow) will ensure that the investor earns a good return.

Furthermore, as the dividend yield of a company increases, it signifies that a company is facing a downturn in their business cycle and as all cycles have their ups and downs, buying a Dogs of the Dow stock with a high dividend yield is a sign that the company will have an upward movement in the upcoming year. Stocks that are currently going through a slump tend to have a low share price that is attractive to many investors.

What companies are the Dogs of the Dow in 2019?

Historically, the Dogs of the Dow stocks have shown positive returns for investors. In 2015 and 2016 they had price gains that beat out the Dow but faced a low point in 2017 as they only had returns of 19% in comparison to the Dow’s 25%. In 2018 however, the current Dogs of the Dow faced losses of 4% that were still significantly lower than the losses faced by the Dow at 6%. While this strategy does not always promise returns, it is appealing to many investors as the high yielding stocks usually have a lower price and is a safer option to buying all 30 stocks in the Dow.

Here are the top 3 Dogs for 2019:

— Exxon Mobil: The price of oil per barrel has increased steadily during 2018 from $60 per barrel to $70 per barrel but ended the year at only $45 a barrel. This is a sign that Exxon Mobil may have an upward turn in its stock prices in 2019. Two factors that can lead to better market conditions for Exxon are the ongoing talks between the US and China along with a cut in oil production by OPEC nations. The second factor is Exxon’s aggressive growth plan that hopes to double their returns in the upstream and downstream business.

— Pfizer: Pfizer’s popular pharmaceutical drug Lyrica had a dip in sales in 2018 and lost a lot of market share in the U.S and Europe. However, with a change in management this year, Pfizer is more optimistic about 2019. Moreover, the company has more than 30 drugs in the pipeline that it hopes to receive approval for by 2022.

— Cisco Systems Although there has been an increase in Cisco’s dividend in the last few years, many investors are choosing to invest in younger tech companies, leaving older companies like Cisco behind. However, Cisco plans to rectify this issue in 2019 as they are turning all their subsidiary services into subscription models which they hope will help them leverage their position in global markets and increase revenue. They also have a 3% yield which is a high value in comparison to other DJIA companies.

Also read: Here Are the 2019 Dogs of the Dow

Closing Thoughts

The Dogs of the Dow strategy is great for investors to diversify their portfolio and receive above-average returns. While the current Dogs of the Dow stocks may not seem to be doing well in the market currently, they are sure to increase in value by the end of the year.

What is a Hedge Fund? And how do they operate cover

What is a Hedge Fund? And How do they operate?

The term ‘hedge’ refers to risk mitigation. Earlier, Hedge Funds used to aim at reducing the risk of decline in prices of securities. Nowadays, it works for generating outsized returns. The hedge fund is not an investment instrument but refers to a collective investment structure set up. Such set up is created by some money manager or registered investment advisor and is generally organized in the form of an LLP (Limited Liability Partnership).

Moreover, the Hedge Fund is a form of an alternate investment structure. It is a private investment vehicle which pools money from high net-worth individuals. Here, fund managers apply aggressive and diverse strategies for generating large returns for investors.

Mutual Fund vs. Hedge Fund

There are a lot of people who have a misconception that Hedge Funds are similar to Mutual Funds. However, the fact is that both are quite different in many respects. For example, Hedge Funds function under less stringent regulations as compared to Mutual Funds. Investment in mutual funds is highly regulated by SEBI.

Further, Hedge Funds have a lower number of investors, but such investors are having higher net-worth. These investors are having higher risk appetite too. On the other hand, Mutual Funds are meant for a large group of people. One can start investing in a Mutual Fund with a small amount as low as Rs 500.

In addition, Hedge Funds adopt more aggressive strategies in managing their investors’ funds. Mutual Funds are not allowed to take short positions in the markets, while Hedge Funds can. So, when the stock market witnesses bearish trend, Hedge Funds can book profits by shorting, while Mutual Funds cannot. Nonetheless, Hedge funds are comparatively riskier than mutual funds as they have a higher amount of leverage.

Also read: The Beginners Guide to Select Right Mutual Funds in 7 Easy Steps.

Strategies adopted by Hedge Funds

It was stated earlier that Hedge Funds use aggressive strategies for achieving superior performance. Let us have a look at some of their most popular strategies used by hedge funds:

— Short selling: Generally, the majority of the investing population takes a long position on stocks which may make the market overpriced sometimes. Hedge Funds exhibit more interest in short selling by going against the herd.

— Equity market long short: This means taking a long position in some underpriced stocks and simultaneously taking a short position in some overpriced stocks. However here, Beta or market exposure is not completely canceled off.

— Equity market neutral strategy: It is similar to the above strategy but here, the market exposure is completely set off, i.e. Beta is zero.

— Event-driven strategies: It indicates making profits from the temporary mispricing occurring during major market events like Mergers & Acquisitions, Buybacks, Demergers, Corporate Restructurings, etc.

How do Hedge Funds operate?

The Hedge Fund industry in India started getting noticed roughly around the 2010s. Therefore, it is relatively young and yet to become popular among the people in our country. Now, let us discuss how Hedge Funds work:

1. Hedge Funds are not required to register themselves with SEBI or any other security market authority in India. In addition, they also do not have any mandatory reporting requirements.

2. You can only invest in a Hedge Fund if you are a qualified or an accredited investor. The investors are generally high net-worth individuals (HNIs) and financial services entities. The minimum ticket size of participating in a Hedge Fund is Rs. 1 crore. While investing your funds with any Hedge Fund, you get units in return like any Mutual Fund.

3. Hedge Funds allocate their investments in high risk-bearing instruments. In other words, they expose their assets to high risk in order to earn huge returns. Moreover, Hedge Funds use leverage extensively.

4. Hedge Funds allocate their funds in diverse investments like stocks, currencies, derivatives, real estates, and bonds. They can invest in a wide variety of asset classes but limit themselves to the mandates.

5. Investing in a Hedge Fund is associated with a long lock-in period. This means you cannot withdraw your investments before the expiry of its lock-in period. This makes investing in Hedge Funds comparatively less liquid than Mutual Funds.

6. Hedge Funds or the category III Alternate Investment Funds has still not received pass-through tax status. It means that the income generated by these funds is only taxable at the investment level. So, there is no tax obligation for the unitholders.

7. Hedge funds work on the concept of both management fee and expense ratio. Globally, the “Two and Twenty” system is followed. It means there is a fixed fee of 2% for the fund managers on the assets under management. Whereas, 20% refers to the income on the profits earned over and above the high watermark. In India, the fixed percentage of management fee could even go below 1% and the profit sharing ratio is usually fixed between 10 to 15%. 

Also read: Performance of Hedge Funds in India

hedge fund memes

(Image credits: www.usagold.com)

Conclusion

The majority of Indian population is still inclined towards FDs and other saving instruments. Although Mutual Funds has started gaining popularity in India lately, however, Hedge Funds are still in the nascent stage in our nation. They are yet to get significant popularity compared to mutual funds as fund houses are allowed to advertise while Hedge Funds are not.

The population of India is over 135 crores where the majority of the country’s wealth is in the possession of top 10% population. A Hedge Fund is an investment structure where the investors are mostly high net-worth individuals. Therefore, in a country like ours, it is highly unlikely that the Hedge Fund industry will become popular fast enough among common masses.

What is Sharpe Ratio? And how to calculate risk adjusted return using it cover

What is Sharpe Ratio? And how to calculate risk adjusted return using it?

The Sharpe ratio is an important metric used to determine the overall return an investor receives on his portfolio and measures the total amount of revenue earned for each unit of risk. The ratio shows the investor how their investment or fund is performing after being adjusted for risk and can help an investor understand how much their risk is worth. It is commonly used to compare the risks of two different investments against a benchmark number. The higher the Sharpe ratio, the better the risk-adjusted return on the investment.

The Sharpe ratio is often favored over a total returns ratio because it takes into account the investors risk when calculating the return. The return ratio, on the other hand, only lets the investor know the total amount of money they will earn on the investment. In certain cases, an investment that generates a high return can have high volatility and many investors find that the returns are not worth the risk. The Sharpe ratio is used to assess risky investments like equity funds where the extra return is seen as an excess risk.

Who invented the Sharpe Ratio?

The Sharpe Ratio was invented by William F. Sharpe, a Noble American Prize winner, in 1966. The Sharpe ratio is widely used today to calculate the risk-adjusted return on investments. In addition to inventing the ratio, Sharpe was also noted for his contributions in developing CAPM which assess’ the systematic risk relative to the return on a stock.

Although the ratio was named after him, Sharpe said that this was unintended. When he first developed the ratio it was called the Reward to Variability ratio but as it became increasingly popular among investors, it soon became synonymous with Sharpe’s name.

How is the Sharpe ratio calculated?

The Sharpe ratio is used to measure the risk-free return on your portfolio and helps an investor place a value on the level of risk undertaken. It can be calculated using the formula:

Sharpe Ratio = (Expected return – Risk-free return) / Standard deviation

The components of the formula: 

  • Expected Return: This could be the expected return on the investment in days, months or years. To arrive at a standard value, the total return is annualized for uniformity. When there are extreme highs and lows, the data can often be skewed.
  • Risk-free Return: The rate of return is considered to ensure the investor is receiving a good return for the risk taken. This is often a benchmark that the level of risk is compared against. For example, government securities are known to have the lowest level of risk and the Sharpe ratio assumes that a similar security purchased for the same duration should carry identical risk.
  • Standard Deviation: this value indicates by how much individual elements in a group are away from the mean and is calculated as the square root of the variance. After subtracting the expected return from the risk-free return, it is divided by the standard deviation to show how far the asset is from the mean risk. The higher the Sharpe ratio, the greater the risk-adjusted return.

Numerical Example

Let’s say that an investor has a portfolio which consists of stocks and bonds. The current expected return on his portfolio is 13% with the market volatility of 4%. The risk-free rate for the securities is valued at 6%.

Now, he is planning to add another asset in his portfolio which may reduce the expected rate of return to 11%. However, the portfolio volatility will also reduce to 2.5% after adding the asset. What should he do? Is it wise to add this asset to his portfolio? Let’s find out the answer using the Sharpe Ratio.

Initially, the Sharpe ratio for his portfolio was:

= (0.13 – 0.06)/0.4 = 17.5%

Nonetheless, after adding the new asset, the expected rate of return and the portfolio volatility will reduce. Further, let’s assume the risk-free rate of return to be constant at 6%. The updated Sharpe ratio for his portfolio will become:

= (0.11- 0.06)/0.25 = 20%

Here you can notice that although the absolute return after adding the new asset is lower. However, there is an improved performance for his portfolio on the risk-adjusted basis which is reflected in the increased Sharpe ratio. Therefore, he should add this new asset to his portfolio.

What is the Sharpe Ratio used for?

The Sharpe ratio measures the total value of an investment, taking into account all the inherent risks involved in a certain asset. Investors use the Sharpe ratio in the following ways:

— To compare two investments- The ratio can be used to compare the risk-adjusted return for two investments and allows you to quantify the excess returns over the risk-free rate. This is useful information to an investor as an investment that has a high return may not always be worth a large amount of risk. It also standardizes different types of investments that allows for easy comparison.

— It helps you decide what to invest in next- The Sharpe ratio calculation can help you pick your next investment. If your existing ratio a lower Sharpe ratio, then ideally you should choose an investment that will increase your Sharpe ratio which would lower risk and increase return. Any investment that decreases the Sharpe ratio is a sign that the investment may not be the best addition to your portfolio.

— High return does not equal a good investment- the Sharpe ratio is a good measure for the risk to return value of an investment. An investment with a return of 9% and low volatility is better than an investment return of 11% with high volatility. The Sharpe ratio takes this volatility into consideration and provides a true return on investment.

Also read:

Warning: Sharpe ratio is not always a good indicator

The Sharpe ratio is used as a comparison between two investments and sometimes there is no indication as to whether all the stocks in the portfolio are concentrated in one sector. If this is the case, an industry that is doing well will result in a high Sharpe ratio but will also be a very risky investment for the trader.

Alternatively, finding the right valued for risk-free-return and the standard deviation is often a challenge for many investors. During unstable economic conditions, historical data may not provide a true reflection of the current market environment. In today’s everchanging market, history rarely repeats itself.

Hence, when using the Sharpe ratio to assess an investment, its value should be considered in addition to other qualitative factors and ratios to help you make informed decisions.

goodwill balance sheet cover

What is Goodwill in the Balance Sheet?

Goodwill is an intangible asset that represents the non-physical items of a company has that cannot be easily valued. It is the excess value of a business after subtracting the assets from the liabilities. This value can be generated from customer loyalty, the quality of the management, the brand image or even the location of the company. Anything that adds value to a company beyond its assets and liabilities is considered goodwill.

Why is goodwill important to a company?

The importance of goodwill comes into play during a merger or acquisition. A buyer who is looking to acquire the company can pay more than the market value due to the business’ intangible assets. When acquiring another business, companies often look beyond the physical assets that the company owns and consider the brand identity, customer satisfaction and efficiency of the staff to arrive at a fair price for the company. The total amount of money that the buyer pays for these intangible assets in excess of the company’s market value is considered goodwill.

Goodwill is subjective and can be a different value for each company. When Facebook acquired Instagram, many people believed that Instagram (a free app that allows you to share images at no cost) was not worth more than $500 million. But after valuing Instagram’s total assets, liabilities and goodwill, Facebook believed that Instagram was worth over $1 billion which is what they paid for it. It is often hard to put a specific value on a company.

What creates goodwill in a business?

There are three factors that makeup goodwill in a business. They include:

1. Going-concern

This includes the existing assets in the business such as the employees and equipment that can be used in the day to day operations of the business. When these assets are functional, they create intangible value for the business known as going-concern. The going concern of a company can be used in one of two ways.

It can either be shown as an individual intangible asset for specific valuation or tax reasons or as a component of the total goodwill in the company. This second method is in accordance with the Financial Accounting Standards Board (FASB) for deriving the fair value of a company.

Going-concern can increase the value of specific assets in the business. For example, the value of a machine will be greater when it is seen as being fully functional and adding value to the business every day versus being valued as a single entity in the company. Going concern can also add value to an intangible asset such as a trademark or copyright. These assets are usually worth more when there are seen as providing continuous value to the company.

2. Excess business income

When a company earns a rate of return that is greater than the fair value of the tangible and intangible assets combined, the excess income is considered goodwill for the company. This excess income cannot be assigned to any specific tangible or intangible asset and is hence included in the goodwill of the company. For example, any income earned by an actor or singer that is in excess of their direct return from their acting or singing abilities is considered goodwill.

3. The expectation of future events

Goodwill can also be created through any future events that are not directly related to the current operations of the business. This can include a merger or acquisition, expansion of the business or new clients. When valuing a company, financial advisors will use the current operations of the business (NPV) in relation to the future events assuming that it will have a positive impact on the company.

The different types of goodwill

There are three different types of goodwill:

— Institutional goodwill

This is the company’s reputation of the company in the market and their ability to serve customers. That is the goodwill created from the collective operations of the business through its assets.

— Professional goodwill

This is the goodwill in professions such as a doctor, lawyer or athlete. It consists of two types:

  • Practitioner goodwill- this is the goodwill created by the skills, talent, and reputation of the professional.
  • Practice goodwill- this is the goodwill created by the business the professional works and includes the location of the business, its reputation in the market and the efficiency of the operations.

— Goodwill as a result of fame

Famous people can also create goodwill through various factors. For an actor, their goodwill is attributable to their skill level while athletes create goodwill through their professional accomplishments and accolades. Top business executives and politicians create goodwill through their skill level and any professional accomplishments.

Also read:

Example

Company X purchased Company Y for $115,000. Business Y has assets worth $100,000 and liabilities worth $20,000. The value of goodwill is:

Goodwill = 115,000 – (100,000 – 20,000) = $35,000

The journal entry for Company X is:

Account Debit Credit
Total assets 100,000
Goodwill 35,000
Liabilities 20,000
Cash 115,000

Goodwill is shown separately in the assets of the buying company’s balance sheet but the treatment of goodwill can vary by the accounting standard followed by the company. Under the IFRS and US GAAP standards, goodwill should not be amortized on the balance sheet every year rather the goodwill should be monitored and only reported on the balance sheet when necessary i.e. during a merger or acquisition.

Under the UK GAAP, goodwill is seen as providing continuous value to the business and should be amortized every year. The intangible assets are included in the financial statements of the buyer at their fair value (the price at which the intangible assets could have been disposed of individually).

Sometimes, the goodwill of a company can be negative (the company is sold at a price lower than its market value). In this case, goodwill is shown as an income on the buyer’s balance sheet.

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

Conclusion:

Goodwill refers to the reputation of a business and is vital to any company in acquiring new customers and retaining existing ones. It also attracts new investors and keeps shareholders happy. Moreover, Goodwill represents the true value of a company, that is, its total worth over and above its market value. The goodwill of a company is often valued by financial advisors for the purpose of taxation, litigation or maintaining financial statements.

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What is Portfolio Rebalancing? And Why is it important?

For the investing world, the term ‘Portfolio’ means a basket of securities. There is a popular saying that- ‘Do not put all your eggs in a single basket’. A similar strategy is applicable for your investments too. While investing in the financial market, it is always recommended to spread your investments across diversified securities to reduce risk. And this collection of diversified financial instruments is termed as a portfolio.

While creating a portfolio one should always aim to build a balanced one. A balanced portfolio can reduce portfolio risk and also offers stability. Let us understand it better with the help of an example.

Suppose Arjun, a 25-year-old salaried guy, has a current net worth of Rs 5 lakhs. Out of his entire worth, he has invested Rs 4.5 lakhs is stocks and has kept the remaining money as cash in hand. Here, although Arjun’s portfolio consists of two different assets (i.e. cash in hand and stocks), however, do you think his portfolio can be called balanced?

What, if the market witnesses a bearish trend for the next two years? In such a scenario, Arjun’s portfolio might look almost all reddened as he has invested 90% of his entire net worth in the stock market.

However, let’s consider another scenario where Arjun has diversified his assets smartly in different securities and his portfolio looks something like this:

— Investment in stocks = Rs 2 lakh
— Investment in debt funds = Rs 2 lakh
— Cash in hand = Rs. 1 lakh

The above portfolio looks a little balanced as Arjun has allocated his investments better this time. In this case, even if the stock market fails to perform well for quite some time, the loss on stocks (if any) will be mostly absorbed by the returns from the debt funds. Therefore, despite the things do not work out as well as planned, Arjun will either lose only a minor portion of his corpus or won’t lose anything at all.

Overall, a balanced portfolio helps the individuals to spread their investments across high-risk instruments to low-risk securities. In the simple example discussed earlier, Arjun has constructed a balanced portfolio by investing smartly in stocks (high-risk securities), debt funds (low-risk instruments) and cash in hand (lowest risk of all).

What is portfolio rebalancing?

So far we have just talked about portfolio balancing or a balanced portfolio.

However, as assets appreciate/depreciate with time, this allocation may change in the future and even a balanced portfolio may not remain balanced over time. In Arjun’s case, suppose his portfolio looks like this after 5 years since he originally invested:

— Stocks = Rs. 3.8 lakhs
— Debt funds = Rs. 2.2 lakh
— Cash in hand = Rs. 1 lakh

Here you can notice that Arjun’s assets have gone up by Rs. 2,00,000 in 5 years. This majorly happened because his investments in stocks have performed well and given him amazing returns.

However, his current portfolio is different from his original desired asset allocation. Initially, his portfolio consisted of 40% in stocks, 40% in bonds and the rest 20% in cash. However, his current allocation consists of 54.28% in stocks, 31.4% in bonds and remaining in cash. Obviously, if Arjun wants to restore his original allocation, he will have to sell a few of his stocks and increase the investments in bonds so that both get adjusted back to 40% each. This activity is called portfolio rebalancing.

Portfolio rebalancing involves periodically buying and selling assets for the purpose of keeping the portfolio aligned to the predetermined strategy or risk level. In other words, during portfolio rebalancing, you’re selling off those securities which you do not require any more and reinvesting the proceeds to buy the instruments you need. Another key point to note here is that in portfolio rebalancing, you are not adding any fresh money to your existing portfolio. You are simply adjusting the allocation in your portfolio.

Why does your portfolio need rebalancing?

Here are a few of the biggest reasons why you need to rebalance your portfolio at regular intervals.

1. If you don’t rebalance your portfolio periodically, it may get riskier with time.

You should rebalance your portfolio at regular intervals to maintain the desired risk level, especially in case of big changes in the market. Furthermore, it is a known fact that as you grow older, your risk appetite decreases. Therefore, in that case, you should develop a habit of constantly shifting your assets from equity to debts to add stability to your portfolio against the risk of loss.

2. It helps is keeping your portfolio in line with your goals/needs

Along with maintaining your existing corpus, improving returns is also necessary to grow your wealth. Equities or Equity based Mutual Funds are mostly used for beating the benchmark indices and earning sufficient inflation-adjusted returns. However, if you find any of your stocks are constantly underperforming for a considerable amount of time, you should consider replacing them with some other securities. A disciplined portfolio rebalancing will ensure that your portfolio is aligned with your financial plan.

3. Portfolio rebalancing helps in planning your taxes.

Equities and Equity based Mutual Funds attract 10% long term capital gains tax if such capital gain exceeds Rs.1 lakh.

If you a small investor, you can consider redeeming your equities in a financial year and invest the proceeds elsewhere. This will not only help in booking profits but will also help you in spreading your tax liability uniformly across the years. Similarly, you can also plan to redeem your investments in such a way that you can carry-forward your previously-occurred capital gain losses or to set off against capital gains to save further taxes in future.

Incurred Costs while rebalancing your portfolio

Portfolio rebalancing is not free as it costs money for buying and selling the assets. Here are a few common costs that you have to incur for rebalancing your portfolio:

1. Whenever you buy or sell any financial instrument, you have to incur a few unavoidable expenses in the form of brokerage, STT, commission, stamp duty etc. Although you can reduce the incurred costs by using discount brokers or investing in direct mutual funds, however, you cannot avoid them completely.

2. You may have to pay some unnecessary taxes: When you rebalance your portfolio, you get involved in selling a few of your investments. This might result in capital gains which attract tax liability on the same. Further, if you rebalance your portfolio too fast and sell your assets, you have to pay Short-term capital gain taxes (which is almost always higher than the long-term capital gain taxes).

3. You may have to pay some penal charges:  If you redeem a few investments before a specified time period (or locking period), you may have to pay some penal charges. For example, if you withdraw your money from your ongoing Fixed Deposit Account, your Banker may impose a nominal penalty. Similarly, if you redeem your Equity Mutual Fund units within a year, you may have to pay an exit load.

Also read:

Closing thoughts

If you want to get into physical shape, the balanced diet is a must. Similarly, if you are willing to generate long term wealth through your investments, creating a balanced portfolio is essential. However, your portfolio will remain balanced for long-term only if you keep rebalancing the same at adequate intervals of time.

To be honest, no one can tell what must be the exact time to rebalance your portfolio. Nevertheless, it is recommended that you should keep checking the allocation of your assets in your portfolio at least every year or two. This will ensure that your investments are in line with your goals/needs.

That’s all for this post. I hope it was useful for you. Happy Investing!

Is Debt always bad for a Company cover 2

Is Debt always bad for a company?

While evaluating a company to invest, one of the biggest element to check is its debt level. Ideally, it is said to look for a company with Zero-debt as it means that the company is able to manage its finances predominantly through internally generated cash without any external obligations.

However, is debt always bad for a company? Should you ignore a stock just because it has some debt. Moreover, what if the debt level increases after you invest in a stock? Should you exit that company because the company is adding debts?

In this post, we are going to answer these questions and discuss whether debt is always bad for a company or NOT. Let’s get started.

How a company finances its debt?

A company can raise debt either by issuing debt securities like bonds, notes, corporate papers etc or by simply borrowing money as loans from banks or any lending institutions. However, once the company has taken a debt, it is legally obliged to pay it back based on the terms agreed by the lenders and lendee.

In general, if a company is currently debt free and later starts taking some debt, it might be good for the business as the company can invest that money in expanding its business. However, the problem arises when the company which already has a big debt in its balance sheet, decides to add more. This increasing debt level can negatively affect the shareholders as by norms, debts are to be paid first by the company and shareholders will always be the last in line to receive profits.

When debt is not bad for business?

Although a few matrices like declining profit margins or negative cash flow from operating activities for a consistently long period is considered as a bad sign for a business. However, the same is not true in the case of debts. The debt is not always bad for business.

If a company has a low debt level and decides to take a new debt to start a project which may double or quadruple their revenue, this debt may be good for the business and add more value to the investors in the long run. However, an important question to ask here is whether the company can afford the debt at that point in time. If yes, then it may not be a point of concern for the company or you as a shareholder.

To check whether the company can repay the debt or not, you can look at the free cash flow (FCF) of the company. As a rule of thumb, if the company’s long-term debt is less than three times the average FCF, it means that the company will able to repay its debt within three years using its free cash flow. Of the other hand, consistently negative free cash flow with increasing debt level can be a warning sign for the investors.

Quick note: Also check out this post by Harvard business review on When Is Debt Good?

Debt is cheaper than equity

For growing a business, the management may decide to raise money from investors (equity funding) or they may borrow money from banks as debts. However, an important concept to understand here is that debt is cheaper than equity.

In other words, equity is a comparatively expensive method of financing for a company. Why? Because, first of all, raising money by equity dilutes the ownership and control of the promoters. Second, the cost of equity is not finite. Here, the investors may be expecting bigger returns as they are taking higher risks.

On the other hand, the cost of debt is finite and they are sourced at lower rates. This is because the debt is less risky financing as the firm is obligated to pay it back (unlike equity funding where the company is not obliged to pay any dividends to the shareholders). Moreover, the company has no obligation to the lenders once the debt is paid off.

Further, debt financing doesn’t result in any dilution and change in control. Here, the lenders take no part in the equity of the company and hence the promoters and shareholders can enjoy the benefits.

How to evaluate the debt of a company?

Although checking the liability side of a balance sheet is always the first step to evaluate the debt of a company. However, there are a few financial ratios that you can use to evaluate the debt level. Here are the three most frequently used financial ratios to evaluate the debt of a company:

1. Current Ratio:

This ratio tells you the ability of a company to pay its short-term liabilities with short-term assets. Current ratio can be calculated as: Current ratio = (Current assets / current liabilities)

While investing, companies with a current ratio greater than 1 should be preferred. This means that the current assets should be greater than the current liabilities of a company.

2. Quick ratio:

This is also called the acid test ratio. Current ratio takes accounts of the assets that can pay the debt for the short term. It doesn’t consider inventory as current assets as it assumes that selling inventory will take some time and hence cannot meet the current liabilities.

Quick ratio = (Current assets — Inventory) / current liabilities

A company with a quick ratio greater that one means that it can easily meet its short-term obligations and hence quick ratio greater than 1 should be preferred while investing.

3. Debt/equity ratio:

This ratio is used to check how much capital amount is borrowed (debt) vs that of contributed by the shareholders (equity) in a company. As a thumb rule, prefer companies with debt to equity ratio less than 0.5 while investing.

Also read:

Closing Thoughts

Contrary to the general belief, debts are not always bad for a company but can help it to speed up the growth. Moreover, debts are a more affordable and effective method of financing a business when it needs cash to scale up. The problem arises only when the management does not control its debt level efficiently.

Pat Dorsey's four moats cover

Pat Dorsey’s Four Moats for Picking Quality Companies

While picking a quality company for long term investment, one of the key element to check is the company’s sustainable competitive advantage or Moat.

If you are new to the concept of Moat, I would suggest you to first read this blog post. Anyways, in general, the Moat can be defined as something that keeps a company’s competitors away from eating away their profits/margins for a stretched time. And hence the companies with big moats are able to generate economic profits for a longer time period.

Although there may be dozens of factors that may be counted as a moat for a company like patents, management, technology, switching cost, entry barrier etc. However, in the book “The Little Book that builds wealth”, Pat Dorsey, ex-director of equity research at Morningstar and founder of Dorsey Asset Management, described that there are only four moats that really matters while picking stocks.

Rest all are either confused moats or not durable for a very long time period. In this post, we are going to discuss Pat Dorsey’s four moats for picking stocks.

A little Introduction to Pat Dorsey’s Moat

“FOR MOST PEOPLE, it’s common sense to pay more for something that is more durable. From kitchen appliances to cars to houses, items that will last longer are typically able to command higher prices, because the higher up-front cost will be offset by a few more years of use. Hondas cost more than Kias, contractor-quality tools cost more than those from a corner hardware store, and so forth.

 

The same concept applies to the stock market. Durable companies — that is, companies that have strong competitive advantages — are more valuable than companies that are at risk of going from hero to zero in a matter of months because they never had much of an advantage over their competition. This is the biggest reason that economic moats should matter to you as an investor: Companies with moats are more valuable than companies without moats. So, if you can identify which companies have economic moats, you’ll pay up for only the companies that are really worth it. 

(Source: Chapter 1 — The Little Book That Builds Wealth)

In his book, ‘The little book that builds wealth’, Pat Dorsey suggested that as a company expands, it attracts more competition. And here, the biggest element that helps the company to remain profitable and beat the competitors consistently, in the long run, is their durable economic moat.

And that’s the reason why a few companies remain highly profitable for decades even in competitive spaces. A few examples of such companies can be Apple, Microsoft, Coca-cola, P&G etc.

Pat Dorsey’s Four Moats That Matters:

Here are Pat Dorsey’s four moats that you should look in a company while picking quality stocks with huge sustainable advantages:

1. Intangible Assets

Intangible assets are those assets that you can’t touch or see. A company can have intangible assets, like brands, patents, or regulatory licenses that allow it to sell products or services at a bigger margin that can’t be matched by the competitors.

For example, Coco-cola. If you look at their products, they are just carbonated sugar water and not much different from any other soda shop that you visit locally to buy cheaply priced drinks. However, when this carbonated sugar water meets the brand value of coke, they are priced way higher than what its competitors do, and still able to make way way more sales and revenue.

Similarly, in the pharmacy industry, if a company has got a patent over a specific drug, it may enjoy high sales without worrying much about the competition. And that’s why Pharmacy companies spend a lot of money on their Research and department (R&D) units.

2. Customer Switching Costs

If the customer has to cost a lot of money, time, efforts or resources to switch from one product to another, it is considered as the switching cost. If the products or services offered by a company has high switching cost (or really difficult for the customers to give up those products) then the firm enjoys a bigger pricing power and profit margin.

A great example of a customer switching cost is MS Excel. Although a lot of better tools compared to Excel are available publicly, however, to make all your employees learn any new tool, the company may have to cost a lot of time and resources.

Similarly, a few other software companies with high switching costs can be Adobe Photoshop, Auto-desk, MS Office etc. All these complicated programs cost a lot of efforts to learn and switching from one to another can be really difficult for the users. Unlearning and relearning these tools demands a lot of time, money and resources like pieces of training, courses etc.

3. The Network Effect

These are those companies whose value increases as their number of users increases.

A few examples of companies with a big network effect in recent days can be social platforms like Facebook, WhatsApp, Instagram etc. People are moving into these platforms as all their friends/peers are using them which makes them more valuable. So even if there are another better social media available, however, if your friends/family are not using them, you might be reluctant to switch there.

A few industries like e-commerce or food-delivery especially enjoy the networking effect. More customers are moving to ‘UBER Eats’ because more restaurants are associated with them. And on the other hand, more restaurants are associating with UBER Easts because more customers are moving into that platform. Overall, the users are inviting the restaurants and vice-versa and the platform benefits from the networking effect.

Another great example of industries with networking effect can be ‘Credit card’ industry. Here, customers are getting attracted to a credit card as they are accepted widely by many merchants. On the other hand, more merchants partner up with the credit cards as they have a bigger customer base. Overall, it’s all about networking effect for these companies.

4. Cost Advantages

These are those companies which are able to find better ways of producing their products or services. They enjoy cost advantages by improving processes, finding a better location, greater scalability, or access to a unique asset, which allow them to offer their products or services at a lower cost than competitors.

In general, the cost advantage is most useful in those industries where substitutes are easily available or for those products/services where the price matters the most for the customers while making their purchase decision.

A few examples of a company with cost advantage can be MacDonald (Standardized, low-cost approach and low-price menu), Walmart (low-cost advantage being scaled up to the massive effect), Vanguard (low-cost index fund that made an enormous impact on the investment world) etc.

Anyways, out of all the different sources to improve cost, Process-driven cost advantage should be carefully studied while evaluating companies. This is because processes can be easily copied. On the other hand, if the company enjoys cost advantages with greater scalability, it can do wonders for the businesses and investors.

Also read:

Closing Thoughts:

In addition to the four moats that matter, in his book, Pat Dorsey also discussed a few other confused moats (things that are not exactly moats) or the eroding moats (the ones which fade away with time) like Technology, Trends, Market Position, and management.

To understand a better picture, I would highly recommend you to read the book “The little book that builds wealth”. It will help you to learn the concept of moat far better while picking quality companies. And moreover, the book is only 210 pages long. You can easily read the entire book within a week.

Finally, there’s one more point that I would like to add before ending this post. A moat on its own is not enough. There are multiple examples of companies with big moats but saturated profits. However, a combination of a moat with strong management, and growth potential is what makes a company a great investment.

3 Dumb Stock Picking Strategies That You Need to Avoid cover

3 Dumb Stock Picking Strategies That You Need to Avoid!

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” – Charlie Munger

Over the last couple of years, since I’ve started investing, I’ve come to know so many strategies followed by different investors. Whether they are- Value pickers (those who buy great businesses at a discounted price), growth picker (those who prefer stocks which are growing at a high pace compared to peers or industry) or income stock pickers (those who invests in stocks which give huge dividends), I have heard of them all.

Apart from them, another category of popular stock picking strategy are the ones who rely on algorithms, programs, expensive arrangements or robo-advisory to pick stocks. And they are also quite successful in making money from the stock market.

However, after interacting with thousands of the Trade Brains’ blog subscribers and also through my personal experience, I’ve also come to know a few dumb strategies that many people use to pick stocks which mostly turn out to be a disaster a few years later down the road. (Btw, I’ve also been a victim of a few such strategies during my rookie days. Therefore, do not feel too bad if you have been using these strategies to pick stocks.)

Now, I totally understand that picking these stupid disastrous strategies are not entirely the fault of the beginners. After all, we are neither educationally trained or psychologically programmed to pick the best strategy that suits our interests. As humans, we generally prefer taking shortcuts and this is one of the biggest reason for the individuals to pick these dumb stock picking strategies.

Nevertheless, knowing the strategies which may turn out to be a catastrophe in the future may help the newcomers to avoid them. Therefore, in this post, we are going to discuss three dumb stock investing strategies that investors need to avoid else it may turn out to be a disaster in the future.

3 Dumb Stock Picking Strategies That You Need to Avoid

1. Investing based on Free Tips/Recommendations.

You are getting consistent stock tips on your phone to buy/sell equities and you finally decided to give it a try. This is one of the most dangerous stock picking strategies. Better you should put that money on a lottery ticket if you are willing to take such a risk.

Moreover, the majority of the free tips or recommendations that you receive on your phone via SMS or WhatsApp these days– are SCAMS. Don’t believe me, then read further regarding the same here: 3 Most Common Scams in Indian Stock Market That You Should be Aware of.

Besides, let’s say you’re discussing the market with a colleague/friend/neighbor and they advised you to invest in a particular stock. Unless they are professionally trained in the market (such as research analyst or investment advisor), most of these recommendations are crap and a definite path for future regrets.

2. Picking a stock because a big investor recently invested in it.

Seriously, this is your strategy? Are you planning to match your investing strategy with that of a big successful investor?

As a matter of fact, you should understand that you can never meet the risk appetite, resources, and exit-strategies of the big investors. There are hundreds of things that may go wrong in this strategy and hence, it’s never a good idea to blindly picking a stock just because a big stock market player invested in it.

Anyways, I agree that following the stock picking strategies and portfolio of big investors can be good learning. However, do your own research before investing and avoid being anchored with big investors’ stock picks.

Also read: Is Copycat Investing Hurting Your Portfolio?

3. Picking a stock because it is continuously going higher

If there is a single lesson that you should learn from this post, then remember this- “Stock prices going upwards is not a reason to buy and prices going down is not a reason to sell.

You should never pick a stock just because it is going higher. Stock prices movement on its own tells nothing.

Here, you need to look into the fundamentals, recent quarterly/annual results, corporate announcements, and other related news to find out the reason of price movement. Always make an informed decision after properly analyzing the company, rather just the price movement.

Bonus

4. Picking a stock because you feel it will go high

Recently, I was talking with one of my friends, Manish, and we begin discussing the equity market. After debating various investing ideas, Manish said that he is planning to buy Tata Motors share because he thinks that its price will re-bounce in upcoming months (Btw, at the time of writing this post, Tata’s share was down by over 57% in last one year).

I knew that Manish didn’t have much investing experience and hence I simply asked why he thinks that Tata Motor’s price will go up. He replied that the price is really down and he’s getting a feeling that the share price will recover and go up in the future.

Now, the share price of Tata Motors ‘may’ or ‘may not’ go up in the future. This is an entirely different discussion which I do not want to start right now. However, the answer that he gave to explain why Tata’s share price may go up is really stupid, right?

If he had talked the stuff like the sales of Tata Motors is going up, or their profit margin is increasing or Tata’s are launching a new vehicle in a segment which may be demanding among the audience, then I might have considered the reasoning. I mean, if someone gives me a factual reason why they believe that the price will go up, then I might discuss it further. However, if the reason is your ‘intuition’ or ‘gut feeling’, I can’t argue much regarding the same.

While investing in stocks, remember that you are not predicting whether it’s gonna rain today or not. Here you are analyzing companies which have fundamentals. There are a lot of pieces of information like the company’s financials, the board of directors talks/speeches, related news etc which are publically available to analyze companies. However, if instead of using these informations, you are making an investment decision based on your intuitions, you should rather be ready for an investment disaster.

Also read:

stock market meme 31

Closing Thoughts:

According to Benjamin Graham, the father of value investing, investment can be defined as “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”

If you want to make decent returns from the share market, you need to stop speculating and making decisions based on these dumb strategies. If you are new to investing, take your time, learn and start building your own repeatable strategy by properly analyzing the companies which may produce consistent returns in the long term.

That’s all for this post. I hope it was helpful for you. Happy Investing!!

thematic investments

Why You Should Try Thematic Investments?

Suppose you believe in an idea and confident that it will perform well in future. For instance, let’s say you are optimistic towards the renewable source of energy. Here, you are assured that the grid and other conventional sources of energy will be replaced by the renewable source of energy like solar or wind energy in the future. And therefore, you want to invest in this idea.

However, you are not certain of the best leading company in this segment to invest. Moreover, you also do not want to invest in the entire energy sector through any sectoral mutual fund as you want to focus just on the renewable energy-related companies. How to proceed further with your investments? Enter the thematic investments.

What is Thematic Investment?

As you might already know, mutual funds also provide an option to invest in different sectors via sectoral funds. For example, pharmaceutical funds focus on pharma companies or banking funds focus on investing in companies in the banking Industry. However, thematic funds are different from the sectoral fund.

Thematic funds are growth-oriented equity funds that focus on investing in a set of companies based (or closely-related) to a particular theme. They follow a top-down approach and targets a broader macro-economic theme on which the fund manager has a good knowledge of. Here, the thematic fund investors studies and understand the impact of structural shift in economics, political, technological, corporate or social trends on sectors, demographics etc which may reveal investable opportunities.

For example, electric vehicles (EVs) can be considered a theme. Here, the thematic fund based on EVs do not just need to focus on one automobile industry, rather they can include a set of industries which are a part of the theme. For example- this theme may include companies from the automobile industry, battery industry, Metal companies involved in making battery parts like Graphite, Aluminium, Carbon, etc, auto-ancillaries industry or any other companies related to the EVs.

A few other popular themes in India right now are digital India, make in India, technological progress, Internet of things, blockchain, environmental sustainability, social security etc.

thematic investments approach-min

Mutual funds vs thematic funds:

As I already mentioned above, thematic funds are different from the mutual funds and here are a few major differences between them:

— Mutual funds are over diversified while thematic funds are compact. Mutual funds invest in somewhere between 40–100 stocks. On the other hand, the number of stocks in thematic funds are smaller, typically between 5–20.

— Mutual funds are rigid and not easily customizable. Although there are thousands of mutual funds available in the Indian market, however, they are not customizable. On the other hand, it’s easier for investors to choose their ideas/sentiments and factor their risk appetite through thematic funds.

— The costs involved with mutual funds are high. For managing a popular active fund, the fund house may charge an expense ratio as high as 2.5-3%. However, the fees involved with thematic funds are comparatively cheaper.

Advantages of Thematic Funds

Here are a few common advantages of thematic funds:

—  Thematic funds are potentially more rewarding compared to diversified mutual funds.

— As thematic funds offer a compact theme, they have a concentrated impact because of news or happenings in other non-related industries.

— There are a lot of publicly available popular themes in the Indian market and hence, finding the right investment opportunity is not a tough task for investors. For example, you can use FYER’s thematic investment platform to try new different themes.

— Thematic funds allow strategic exposure to the investor’s portfolio and encourage common sense investing as themes represent the investor’s ideas and thoughts.

The risk associated with thematic funds:

There’s no denying the fact that no investment strategy is perfect. And the same goes to the thematic investments. By making investments in thematic funds, you are preferring a concentrated theme. This portfolio concentration makes these thematic funds comparatively riskier over diversified mutual funds.

Moreover, there’s also a controversy regarding thematic investments which says that investing in a concentrated idea which is still untested and underappreciated, may not be a sound approach.

Also read:

Closing Thoughts:

A major difference between thematic investments and traditional ones is that the thematic investors look into the future and makes decisions based on the predictions on the future trends or upcoming shift in the structure. On the other hand, traditional investors check the history and weights more importance to past performance, market behavior etc.

Moreover, we cannot deny the fact that themes change fast with time. In the last two decades, we have witnessed massive changes in the industrial and technology theme. Therefore, if you are planning to make thematic investments, be observant and careful regarding the entry and exit decisions. Only enter these funds after you have researched the idea thoroughly.

Nonetheless, if you are able to invest in right thematic funds, they are capable of giving huge returns to the investors compared to other index or diversified funds.

6 Best Investment Options for NRIs in India

Since last two decades, India has been rapidly developing as an industrial hub. Day after day, our country is attracting more and more foreign direct investment (FDI). Moreover, these days we can see more and more investments coming from the NRIs to the Indian markets. And this is all happening because the Indian economy and government are offering adequate stability and flexibility to the investors. Not only India is conducive for business growth but our economy is also equipped with an extremely profitable financial market.

The year 2018 was not an immeasurable year for investing in the stocks as it witnessed significant bleeding throughout the year. Nonetheless, a similar situation was observed in any other country across the world. However, if you have a look at the year previous to that i.e. 2017, you would find that India’s stock market yielded around 29% return which was relatively higher than any other economy in the world.

Anyways, financial markets are subject to lots of ups and downs. It goes without saying that you need to undertake end-to-end research before you make your investment decision. Nevertheless, whatever investment option you opt for, it should always depend on your financial goals, liquidity requirement, risk appetite and expected returns.

In this post, we are going to discuss a few of the best investment options for NRIs in India which can provide them with adequate returns depending on their goals and needs.

6 Best Investment Options for NRIs in India.

Here are a few solid investment options in India where you can consider investing if you are an NRI.

— Fixed Deposit

Investing in Fixed Deposit is not only popular among the residents in India but also an attractive investment scheme for the NRIs. Being an NRI, you can open your FD with your NRE, NRO, or FCNR Account. All three of these are the types of bank accounts that an NRI can open in India.

Anyways, how much rate of interest will be applicable to your FD depends on the tenure of your deposit. In general, you can expect to earn interest between 6 to 7% on your account balance. Further, if you are a senior citizen, you would get the privilege of earning an extra interest of one percent. Moreover, this investment option is suitable for risk averse investors as FD is a comparatively safer form of investment.

Note: You can read more about the current Fixed Deposit rates in India here.

— Equity

In case you are an aggressive investor, you can consider investing in the equities listed in the Indian market. If you are an NRI, you can directly invest in the Indian stock market under the Portfolio Investment Scheme (PINS) of the RBI.

As an NRI, in order to invest in the stock market in India, you are required to have a bank account (NRE or NRO Account), a trading Account (with a SEBI registered Stock Broker), and a demat account. However, the maximum amount of your investment in the stocks of an Indian company cannot exceed 10% of its paid-up capital.

Further, this is to be noted that, as an NRI, you are not at all permitted to carry out intraday trading and short selling in India. This implies that you need to own the stocks before you can sell them.

— Mutual Fund

These days AMFI is working hard to promote Mutual Funds among the Indian population. Mutual Fund organizations pool money from their investors and then invest the same in the different financial assets. Mutual Funds have moderate risks as they are neither as risky as direct trading in stocks, nor they are as risk-candid as FDs. Further, mutual Fund investments can be highly profitable. There are a plethora of schemes available for Mutual Fund which can choose depending on your risk appetite and financial aspirations.

Anyways, if you are a person residing outside India, you would, unfortunately, face some limitations in mutual fund investing in India because of some rigid FATCA regulations. You are required to have an NRE or NRO Account for investing in the Indian Mutual Fund industry. Furthermore, you also have to invest in Indian rupees and not in any foreign currency.

Note: If you are new to mutual funds, check out our beginner’s resources for Mutual Fund Investing.

— Public Provident Fund (PPF)

A safer form of investment similar to FD is Public provident fund. PPF is an investment alternative which is backed by the Indian Government. Even if you are an NRI, you can invest in PPF. However, here the maximum limit is Rs 1.5 lakh in a financial year.

You can open your PPF account through a post office or through a branch of any nationalized bank in India. Although PPF comes with a lock-in period of 15 years it is definitely more tax efficient than FD. To know more about PPF, you can read this blog on our website.

— National Pension Scheme (NPS)

If you are looking for another tax-efficient investment option, you can even consider investing in NPS (National Pension Scheme). This is also cost-effective, easily accessible, and tax-efficient way to invest your money.

National Pension Scheme is an Indian Government sponsored pension system. If you invest in this instrument, your entire capital during maturity is treated as tax-free. Apart from that, you are not required to pay even a penny to the government as tax on the amount that you withdraw as pension. If you are an NRI aged between 18 and 60 years, you can open an NPS Account to start investing in this scheme. Click here to know more about NPS.

— Real Estate

It’s a fact that there are a lot of NRIs who stay abroad but look to buy their own house in India. Indian population is ever-growing and this is itself paving way for the advancement of Real Estate business in the nation. Being an NRI you can invest in a house property in India from where you can earn handsomely by letting it out to a third party.

However, this is to be noted that, you have to make any such purchases only in Indian rupee. Furthermore, you can’t buy agricultural lands, farmhouses, and plantations in India. Nonetheless, there is no restriction on you to inherit any such property or accepting them as gifts. Check out more on Real Estate investing in this article.

Closing thoughts

In this article, we tried to cover some of the best investment options for NRIs that they can consider if they are  planning to invest their savings in India from abroad.

If you are a profit-loving investor and looking for a long term capital appreciation, you can choose to invest in the Indian stocks or mutual funds. In case you are having a huge corpus, high risk appetite, and high return expectation, you can invest in the real estate sector. Besides, you can invest in an FD if you have a short investment horizon and looking for a guaranteed return. Lastly, you can opt for investing in PPF or NPS if you are willing to earn tax efficient returns and at the same time not bothered to park your money for a longer period of time.

Overall, nn the basis of your priorities, budget and expected returns, you can make a choice of any investing scheme that suits you in the most effective manner. While making any investment in a financial instrument, ensure that you have gone through the relevant documents and understood the salient features of the same.

Our best wishes on your investment journey. Happy investing!

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Warning: Random Walk Theory may change the way you look at stocks

The Random Walk theory is a statistical model of the stock market that shows that stock prices with the same distribution can be independent of each other. In other words, the prices of these securities are not influenced by past events in the market.

The random walk theory was developed by Burton G Malkiel, a professor at Princeton University and was discussed in his book A Random Walk Down Wall Street. The theory applies to trading securities and states that movements in the price of a stock are random and that any research conducted to predict future price movements is a waste of time.

What is the random walk theory?

The random walk theory does not involve the technical analysis of a stock which uses historical data to predict future prices. Nor is it a fundamental analysis to study the financial health of a company. It is, however, a hypothetical theory that states that the prices of the stock move at random. The random walk theory asserts that stock returns can’t be reliably predicted, and stock movements are just like the ‘steps of a drunk man’, which no one can foretell.

This theory is based on the assumptions that the prices of securities in the market moves at random and the price of one security is completely independent of the prices of the all the other securities.

It’s as random as flipping a coin

A random walk down the wall streetThe concept of random walk theory goes all the way back to a book published in 1834 by Jules Regnault who tried to create a ‘stock exchange science’. This was further developed by Maurice Kendall in a 1953 paper that suggested that share prices moved at random. The hypothesis was popularised by Malkiel in his best selling book A Random Walk Down Wall Street.

To prove his theory Prof. Malkiel conducted a test. He gave his students a hypothetical stock worth $50. At the end of the day, he would flip a coin which would determine the closing price for the stock. Heads meant the closing price would be a half point up while Tails meant the price would be half-price down. This meant there was a 50-50 chance of the price going up or down. Prof. Malkiel and his students tried to determine the market trends from the prices.

Using the results gathered from the test, the professor went to see a chartist. A chartist is a person who predicts future movements in stocks based on past trends and believes that history repeats itself.

Looking at the results, the chartist told the professor to buy the stock immediately. However, the coin flips were random and the stock did not have any historical trend. Prof. Malkiel used this example to argue that movements in the stock market were as random as flipping a coin!

What are the implications of random walk theory?

Many people only invest in a stock because they believe that is worth more than they are paying. However, the random walk theory suggests that is not possible to predict the movement in the stock prices. This means that investors cannot outperform the market in the long-run without taking on an inordinate amount of risk. The only solution is for an investor to invest in a market portfolio (such as an index) which is a representation of the total stock market. Any changes in the stock prices in the market will be reflected in the portfolio.

In addition to this, if the short-term movements of stock are random, investors can no longer buy stocks based on the time-value of money theory. Therefore, a buy and hold strategy will be ineffective as stocks can be bought and sold at any point of time.

Criticisms of the theory

One of the criticisms to the random walk theory is that it ignores the trends in the market and various momentum factors that have an impact on the prices. Many critics say that the price is affected by many trends and very often these trends are very hard to identify and it may take a large amount of historical data and fundamental analysis to figure it out. But just because these trends are hard to recognize, it doesn’t mean that they don’t exist.

Another criticism states that the stock market is vast and there are a countless number of elements that can have a large impact on stock prices. There a large number of investors in the market and each trader has a different way of trading. Hence, it is likely that trends emerge over a period of time which would allow an investor to earn a return in the market by buying the stock at low prices and selling at high prices.

Also read:

A Non-random walk

As a refute to the random walk theory, there are a number of technical analysts who contend that the price of a stock can be predicted on past trends and historical data. They believe that traders who can analyze these trends and make predictions have the ability to outperform the market with their superior knowledge.

Then there is the luck factor. The random walk theory states that only way a trader can outperform the market is purely by chance. This is an inaccurate statement, however, because there are some traders such as Paul Tudor Jones who managed to continuously outperform the market. It is more likely that technical analysis of the stock market is in play here and not just dumb luck.

However, it is important to remember that technical analysis can only help predict the probable changes in stock prices and not the actual price.

Conclusion

Choosing to trade based on the random walk theory is based on the preferences of each trader. If you believe that stock prices are random, it would be best to invest in a suitable ETF or mutual fund and hope for a bull market. But if you truly believe that trends and predictable and that stocks can be traded based on historical data then you should use your technical and fundamental analysis skills to actively trade in the stock market.

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Is Negative Price To Earnings a Bad Sign for Investors?

Price to earnings ratio is definitely one of the most frequently used valuation ratio used by the investors to evaluate a company. Although I do not use this ratio too often, however, every now and then I check the PE of companies and industries to try to look them from a different angle.

Recently, I was going through the list of companies which are not making profits, in other words, losing money. Therefore, I run a simple query on stock screener to find the list of companies with negative earnings per share for the trailing twelve months.

Not surprisingly, I found the names of a lot of big companies in that list. A few of such companies with negative Earnings per share (EPS) for the trailing twelve months were State bank of India (SBI), Lupin, Adani Power, Tata Communication, Idea, Bank of Baroda, Future consumers etc. Here is a detailed list of such companies:

company with negative earnings

(Source: Trading View)

And obviously, when the earning of a company is negative, their Price to earnings will also be negative. Seeing so many big names in the list of companies with negative PE, it is easy to conclude that there will be thousands of people investing in companies that are losing money.

Therefore, in this post, I decided to discuss whether negative price to earnings of a company a bad sign for the investors. Let’s get started!

How Price to Earnings ratio is calculated?

As the name suggests, Price to earnings ratio is calculated by dividing the current market price per share by its earning per share.

PE ratio

For example, if the share price of a company is Rs 100 and the annual earning per share is Rs 20, then the Price to earnings ratio will be equal to 100/20 i.e. 5.

PE ratio of a company reflects how much people are willing to pay for that share compared to each Rs 1 in earnings. For example, for a company with a PE ratio, 5 means that the people are ready to pay a premium of 5 times for every Rs 1 of earnings. And obviously, the lower this premium, the better it is for the investors.

PE ratio is frequently used by the investors to find if a stock is undervalued or overvalued. Usually, a company with a lower PE ratio is a better valued. For example, a company with PE of 8 is comparatively undervalued against a company with a PE of 12.

Also read: No-Nonsense way to use PE Ratio.

Negative Price to Earnings

Basically, the share price of a company cannot go negative. Therefore, if the price to earnings is negative, it means that the company has negative earnings.

Although it is advisable to invest in companies with lower PE ratio, however, when this ratio becomes negative, it might not be favorable for the investors.

A negative price to earnings means that the company is not making profits and hence, why do you wanna invest in companies who are losing money? As a thumb rule, avoid investing in companies with negative price to earnings. If you want to live by a single rule for PE, then this might work perfectly well for you.

Moreover, a company with consistent negative PE means that it is not able to generate profits for a long period of time and therefore, it may fall into trouble while running its normal business operations and in the worst case, it may face the risk of bankruptcy.

Quick note: Most financial websites do not show the negative price to earnings for a company. In general, they will use the word ‘Not applicable’ or ‘ — ’ for the companies with a negative price to earnings.

When negative price to earnings might not be a bad sign.

A few industries like pharmaceutical or technology may have negative earnings if they are extensively spending in their research and development. Although it may be unfavorable for them in the short run, however, if they are able to spend their money in the right direction, it may be a good expenditure for the long term.

For example, if a pharmaceutical company is able to build a medicine for a rare disease and gets a patent for it, the company may generate a lot of profits through that research in the future.

Similarly, if a technology company is able to create a disruption through its research (a few of such trending technologies right now are artificial intelligence, deep learning or blockchain), they might be able to create a competitive advantage and generate profits in long run. And therefore, many investors are willing to invest in such industries even when they are not making money.

Note: Sometimes, a company may also have a negative PE because of the change in accounting norms or because of a few unexpected occurrences. In such scenario, you should not consider it as a bad sign and may wanna investigate further.

How to correctly analyze negative PE ratio?

While studying the price to earnings of a company, compare the PE with the competitors and historical performance. If the company’s PE is consistently falling for the last many years, it may be a warning sign. Further, if the PE of all the other competitors is positive and decently high, then the negative price to earnings for that company may be a caution sign.

Further, comparing the price to earnings of the company with the industry average can also give you a rough idea regarding the situation of that company.

Also read: #19 Most Important Financial Ratios for Investors

Closing Thoughts

In general, it is preferable for the investors to stay away from companies with a negative price to earnings. As an investor, you should find fundamentally strong companies to invest which are consistently making money.

If a company is consistently reporting a negative PE for a longer duration of time, then you should be concerned about it. Anyways, in a few industries, have a look at the company’s expenditure on Research and development by peeking in their income statement. This can give you an idea if the company is working on any cutting edge research or simply losing money in their operations.

Finally, never make your investment decision based on just one ratio. Price to earnings ratio is just a valuation tool. Apart from PE ratio, also look into other quantitative and qualitative aspects before making your choice.

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What is Deep Value Investing?

Deep value investing is an intense version of value investing which focuses on buying stocks at a much higher discount to intrinsic value in comparison to value investing. This results in an increase in the potential reward and risk of the investment.

Background

Traditional value investors have the belief that the market will misjudge stock prices in the short-term and hence they prefer to conduct their own fundamental analysis on stocks that they feel may be undervalued. They first determine the intrinsic value of these stocks and compare it with their current market value. Value investors usually invest in stocks where the market value is below its intrinsic value.

Nonetheless, value investors don’t invest in every undervalued stock they come across as each investor has a different level of margin of safety with regards to the market price and intrinsic value. The major difference between value and deep value investing is that deep value investors require a higher margin of safety.

This high margin of safety means that the return potential of the stock will be high but the risk associated with the stock increases as well. Hence deep value investing is usually followed by those investors who understand their strategies and can fully trust their investment decisions.

Benjamin’s Graham’s deep value investment philosophy

Benjamin Graham defined intrinsic value as the value that a businessman places on a business. He believed it was more important to assess the true value of a company based on the numbers present on financial statements such as the assets, earnings, and dividends. He would use these figures to come up with the fair value of the stock. (Also read: How to Find Intrinsic Value of Stocks Using Graham Formula?)

However, Graham would only buy the stock if it was discounted at 1/3rd (or more) of its intrinsic value. For example, if the intrinsic value of a stock calculated by Benjamin Graham turns out to be at $162, then he would only consider purchasing that stock if it is trading at $108 or less.

Anyways, there are multiple calculation methods that investors can use when valuing stocks such as Discounted cash flow (DCF) analysis, dividend discount model (DDM) and relative valuation tools like the price to earnings, price to book value or price to sales.

How do deep value investors assess the fair value of the stock?

Deep value investors usually buy stock in companies that trade below their liquidation value-although finding such companies is rare. In assessing the fair value of the stock, deep value investors use valuation methods that range in their level of conservativeness. Following are the ways, deep value investors assess the fair value of a company’s stock:

  • Most of the low conservative deep investors look at the future earnings of a company ignoring the fact whether the company has a competitive advantage or not. However, there are also a few investors in this group who look at the firm’s competitive advantage which can be used in the future to earn much higher returns.
  • Slightly conservative deep investors look at the firm’s ability to produce a profit. The earning power of the company is mostly determined based on past earnings with reference to price to earnings (PE) ratio.
  • Highly conservative deep investors look at the book value which involves looking at all the assets held by the company to determine its fair value. They also check Net current asset value, Networking capital and dividends.

Deep value investors use highly conservative strategies the most when looking for stocks that are traded at very low prices.

Deep value Returns

If you are a new investor, you need to use simple strategies that yield the highest return. In other words- deep value is the way to go. Deep value investing in coherence with traditional investing can help an investor earn very high returns. When conducting a conservative assessment of stock value, those stocks with a low price relative to book and current asset value generate very high returns. But remember with higher reward come higher risk.

Deep value Risk

The major risk involved in deep value investing is ending up in a value trap. This is where a stock may seem to be a good investment based on a quantitative analysis with financial ratios like low PE, low price to book value. However, the investor may overlook the ‘qualitative’ factors associated with the stock.

There is often an underlying reason why such stocks trade at a low price. It could be the result of problems with the management of the company or the lack of growth potential. There can be a fundamental problem in the company that is not reflected in its finances. Whatever it may be, an investor needs to be able to spot the reason for the low stock price. If they fail to do so, they end up in a value trap.

Also read:

Conclusion

Deep value investing can reap high rewards if you are willing to take the risk. A deep value stock usually exists when the company is in a difficult situation. It may take time for the company to recover and eventually generate returns. However, as with any investment, you need to be patient.

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What is the difference between Face Value, Market Value & Book Value?

Recently when I was navigating my Quora profile, I got an answer request for the question what is the difference between face value and market value of a company. Although both these are elementary terms related to stocks, however, they may be a little confusing for the beginners. Therefore, I decided to write a simple blog explaining the difference.

In this post, we are going to discuss the difference between Face Value, Market Value, and Book Value of a stock. Let’s start with the easiest.

Market Value

Market value per share is the current value of the stock. This is the price at which market values the stock. For example, if a stock is trading at a share price of Rs 100, then this is the market value per share of that company. The market value per share of a company fluctuates continuously throughout the trading time period.

Further, the total market value of a company, also referred as the market capitalization of the public company, is calculated by multiplying the current share price of the company by its total outstanding shares. 

face value and book value-minFace Value

Face value (also known as par value) is the value of a company listed in its books and share certificate. The company decides the face value when it offers shares at the time of issuance. The face value of a share is fixed (until the company decides to split or reverse-split the shares).

For example, during the IPO of Avenue Supermart (Parent company of D’mart Supermarkets), the management decided the face value per share to be Rs 10. Here is the details:

D mart IPO-min

(Source: Avenue supermart IPO details- Chittorgarh)

In general, the face value of a company is lower than its market value. For example, when a company goes public, it can have a face value of Rs 10. And it may trade at a market price of Rs 500.

However, this case is not always true. For example, in the case of penny stocks, the face value of the company may be higher than its market value. Penny stocks are those companies which trade at a share price less than Rs 10. Therefore, here the market price may be Rs 5 and the face value of the company may be Rs 10.

Further, the face value of a company is not affected by whether the market price goes up or down. However, the face value of a company will reduce in the case of a stock split. For example, if the current face value of a company is Rs 10 and it announces a stock split in the ratio of 1:1. Then, the face value of that company will split in the same proportion. Here, the face value will change to Rs 5 as the total number of share doubles after the stock split.

Also read: Stock split vs bonus share – Basics of stock market

Book Value

In simple words, the book value of a company theoretically means the total value of the company’s assets that shareholders will receive in case the company gets liquidated i.e. when all company’s assets get sold and all the liabilities are paid back to all the debt-holders. Therefore, book value can be considered as the net value of the company reflected in its books.

The book value is calculated as total assets minus intangible assets (patents, goodwill) and liabilities. When you divide the book value of a company by it the total number of outstanding shares, you arrive at the book value per share.

You can compare the book value per share of a company with its market price to find whether the company is under or overvalued. Further, its always advisable to invest in companies with growing book value over time.

For example- here is the book value of ASIAN PAINTS:

face value and book value-min

(Source: Moneycontrol)

Where to find the face value, book value and market value of a company?

The face value, book value and market value of a company can be found on almost all financial websites.

Whenever you open the company page on any financial websites, the first thing that you’ll notice is its market value per share. However, just by cruising a little, you can easily find face value and book value per share of the company. For example, here is the face value, market value and book value per share for Asian Paints. (Source- Screener).

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(Source- Screener)

You can also find this information on other popular financial websites like Yahoo Finance, Marketsmojo, Equitymaster etc.

Also read:

Bottom line

By now, the meaning of face value, market value, and book value should be clear to you. All these three terms are different and one should not get confused among them while studying any company.

Market value per share is the current value at which the stock is trading in the market. Face value is the value of a company listed in its books of the company and share certificate. And finally, the book value of a company is the total value of the company’s assets that shareholders will receive in case the company gets liquidated.

That’s all for this post. I hope it was useful to you. Happy Investing!!

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How do oil prices affect the stock market?

Crude oil is considered to be one of the most important commodities in the global economy. It is versatile in its uses and helps industrialize economies. A variety of things from plastics to rubber and machinery uses crude oil or its byproduct, making it a crucial element in the raw materials for many businesses in the economy.

Hence it is no surprise that the stock market is often influenced by the price of oil. It can affect an individual investor or have a domino effect on the stock market. Here are some of the ways oil prices affect the stock market:

How do oil prices affect the stock market?

– Profitability of oil companies

The oil business has two main components to it, the upstream and downstream business.

The upstream business is involved in the drilling of oil wells and the manufacture of crude oil in industries. Examples of such businesses include Oil India and Shell.  When these companies are profitable it usually results in high stock market prices because the crude oil manufactured by these companies is the raw material for many businesses.

If upstream companies find it hard to drill for oil and face an increase in research and development costs, it could have an adverse effect on the value of the oil company’s stock.

The second type of oil business is the downstream business. These are corporations involved in the distribution and retail function of crude oil. They are in control of your local gas stations such as Indian Oil and Bharat Petroleum. These companies find low crude oil prices beneficial as they can now purchase crude oil at a low price from upstream companies.

– Consumer Demand

Almost everything that a person consumes is tied to oil such as electricity or fuel for their cars.

An increase in the price of oil can raise the daily living costs for people, reducing the amount of money they have available to spend on other goods and services such as electronics or clothing. The revenue of these companies decreases as consumer demand for their goods and services falls. The negative effect on the earning of firms lowers the value of their stock.

Alternatively, a decrease in oil prices has the opposite effect. When consumers spend less on fuel, it gives them more money for other goods and services. The increase in demand raises earnings and has a positive impact on the stock market.

How do oil prices affect the stock market cover

– Profitability of other industries

Since all businesses use a byproduct of oil, an increase or decrease in the price of oil can indirectly affect them as well.

If the price of oil increases, a delivery services company will face higher fuel costs. These costs will be translated to consumers as high prices for their services. The low earnings of the company will result in low stock prices for the industry.

Likewise, if oil prices decrease, the companies can charge lower prices to consumers and have high profitability and higher share prices. In reality, however, companies rarely lower the prices of goods and services if the price of raw materials has decreased.

– Impact on Inflation

The price of oil can directly or indirectly increase or decrease costs of goods and services in the economy and can result in inflation. In the United States, the price of oil is not considered a factor when the inflationary rate is calculated but its price can cause a ripple effect in the economy through industries that use crude oil as a raw material.

If oil prices rise, it can increase the cost of living for individuals, putting a pressure on wage rates to make up for this. The high labor costs increase the costs of goods and services and increase the rate of inflation in the economy as each dollar can now buy fewer goods and services. When inflation rises the stock prices of the industry decline.

Also read:

– Effect on Imports

For countries such as India that import almost 80 percent of its crude oil, a decrease in the price of oil is beneficial because it decreases imports expenditure and stabilizes the exchange rate of the currency.

However, a reduction in oil prices isn’t always great for the stock market. There is a positive relationship between the Foreign Direct Investment and the price of oil. When the price of oil goes up, oil-rich countries invest in emerging oil markets like India. However, when prices go down, they withdraw their investments.

Hence with a fall in oil prices, few foreign investors will invest their money in the Indian stock markets resulting in a negative impact on stock prices.

Conclusion

The versatility of the crude oil has made it an influential factor in the increase and decrease of stock prices. The price of oil not only affects the stock of oil companies but also the stocks of industries that use it a byproduct of it.

While the exact amount of influence it has on stock prices cannot be calculated, the price of this commodity can increase or decrease the total costs of production of many goods and services. This can affect the amount of goods people consume to exchange rate and the level of foreign direct investment which collectively affect the stock prices in an economy.

Needless to say, the price of crude oil has the ability to affect the level of investment in the economy and influence stock prices.

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How to find the last 10 year financial statements of Indian Companies?

Reading the financial statements of a company is a key part of fundamental analysis which no investor should ignore.

Here, the investors need to read at least 5-10 years financial reports of the company in order to understand its performance, growth rate, trends, consistency etc. For example- a high profit for just one or two years is not sufficient to approach at any conclusion. However, if you can find that the bottom line of the income statement is consistently growing at a good pace for the last 5-10 years, this may be a healthy sign for the company.

In short, it’s imperative for the investors to read (and understand) the financial statements of a company before investing.

However, for the beginners, finding the last 10-year financial statements of Indian companies may look a tedious job. Besides, because of so many paid/subscription-based plans available for detailed financial statements of companies, it might be a little challenging for the newbies to decide whether to go for a paid plan or surf the internet to download the reports for free.

Paid plans are generally beneficial as they provide comprehensive reports and tools. However, they are often more useful to the professions, rather the retail investors. For the common investors, it’s better to use the free websites/resources to find the last 10 year financial statements of Indian companies.

In this post, we are going to discuss the free websites and resources to find and download the financial statements of Indian companies. Let’s get started!

How to find the last 10 year financial statements of Indian companies?

1. Company’s official website

The company’s website is the first and foremost source to find its financial statements. You can download the quarterly and annual reports of any company by visiting its official website and navigating to the ‘Investors’ or ‘Investor’s relations’ page.

tcs website

However, to arrange the last 10-year reports, here you might have to download the annual reports one-by-one manually. Nonetheless, this is the best source for the investors to download the financial statements of publically listed Indian companies.

2. Financial websites.

There are a number of free financial websites in India which provide the customized five to ten years financial statements of Indian companies, all at one place. Two of simplest financial websites that beginners should know are:

Screener is a simple, clean, yet powerful website. Here, you can also download the financial statements of a listed Indian company in the excel sheet.

For downloading the financial statements, simple go the screener website and search for your interested company in the search bar. Next, go to the company page where you can find ‘Export to Excel’ option.

screener asian paints

Quick Note: You need to create a login account on Screener in order to download the excel report.

Money control is probably one of the most popular financial websites in India for researching stocks and other financial instruments.

To download the financial statements of the Indian company, go to the company page on the money control website. Next, select the ‘financials’ option in the left tab and click on the financial statement (profit and loss statement, balance sheet or cash flow statement) that you would like to download.

moneycontrol

A few other websites that you can visit to find the financial statements of Indian companies are Yahoo Finance, Equity Master, Marketsmojo, Marketsmojo etc.

Also read: 7 Must-Know Websites for Indian Stock Market Investors.

3. Stock exchange websites

bseindia-min

Finally, you can always visit the stock exchanges (NSE/BSE) website to download the financial statements of an Indian company. The exchanges are continuously working to improve their website and its UI is far better compared to what it used to be a few years ago.

To download the financial statements, search for the company name in the top search bar and open the company page. You can find the annual results and reports in the financial section on the company page. 

Also read:

Closing Thoughts:

Although there are so many options for the investors to find the last 10 year financial statements of Indian companies, however, the easiest and best one is the company’s official website.

A notable problem with the financial websites is that they have to adjust the financial data a little to customize with their layout and hence the data shown on their website may not be exactly accurate. Moreover, there have also been cases where the financial data reflected on these financial websites doesn’t match with that of financial statements declared by the company (this may be because of human or computer error while gathering the data). Therefore, its always advisable to download the annual reports of the companies from their official website while researching the company as it is a more reliable source.

Nonetheless, an easier approach that investors can follow is to use these financial websites for a quick study and later download the annual reports from the company’s website/NSE/BSE while performing the detailed study.

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

6 things you should NOT do when the stock market is volatile cover

6 things you should NOT do when the stock market is Volatile!

Investing in the stock market is known to provide some of the highest long-term returns and can earn investors a profit in manifolds over the years.

People invest in stocks to reach their financial goals and earn a profit on their savings. It is a way to make money work for you rather than you working for the money.

What is stock market volatility?

Investing in stocks is a risky business. While investors can earn a high return on shares, we cannot overlook the volatility that comes with it.

Volatility can be described as the continuous change in the prices of stocks over a short period of time. Here, the price of stocks can rise on a certain day and can fall the very next day. For example, you may have seen situations where Sensex may have fallen over 400 points in a day and recovered on the very next. This can be considered as volatility.

High volatility also increases the VIX ratio (Volatility Index) also known as the Fear Index. It measures the amount of fear in the market as a result of the volatility.

The fear caused by a volatile market makes investors react in many different ways. Some start to panic as their investments get riskier and try to sell & exit the market. On the other hand, there are contrarian investors, who prefer investing only in situations when others are selling. Anyways, as shares start to lose value, investors often make hasty decisions that can result in terrible outcomes.

6 things you should NOT do when the stock market is volatile!

Here are six things investors should not do when the stock market is volatile:

1. Don’t Panic!

The number one reaction investors have when there is volatility in the market is to panic and make speculations. It is important not to be influenced by fear and do something irrational. Investors can consider buying a stock at a lower price but should not panic-sell. Instead, they should use this period of volatility to evaluate the stocks in their portfolio.

There are often many reasons why a person invests in a particular stock in the first place. If the fundamental values of why you invested in the stock are clear, then you should remain invested. However, if you are not sure of a particular investment, meet with your financial planner to decide a course of action to exit the market.

Remember, volatility in the market is only short-term, don’t panic-sell if your long-term objectives of investing in the market haven’t changed.

panic selling

2. Don’t buy JUST BECAUSE prices are low!

When there is volatility in the stock market it is not advisable to invest in the market just because prices are low. This is because there is no guarantee that a stock with a low price today will increase in value in the future. In fact, the price may go even lower and you could end up in a value trap. (Also read- What are value traps?)

You need to analyze the stock’s fundamentals and track record. Look into factors like revenue growth, profit margin, price to earnings, debt-to-equity ratio etc as well as its future potential. If the stock shows a history of riskiness and volatility it would be best not to invest in them. Don’t be a bottom fisher!

3. Don’t believe everything you see on the news!

A sudden ‘breaking news’ segment on the stock market can cause people to make investment decisions that can prove to be disastrous in the future. News reports are not always authentic and often mislead or misguide the investor which can affect the sustainability of a stock.

News reports about the volatility of stock markets are usually short-lived and stock prices will bounce back like a ping-pong ball before you know it. This short-term volatility is often due to a current event in the economy. Once the event has passed, your stock price should be back to normal. As a serious investor, be aware of ‘breaking news’ but don’t follow it blindly.

news

4. Don’t make decisions based on international markets!

During certain periods, there can be a correlation between local and international stock markets. For example, a change in the leadership of a country could affect numerous economies around the world. But statistically speaking, such a correlation does not exist most of the time.

Volatility in the stock market is a reflection of individual events in an economy or movements in the economic cycle. The stock prices are a result of the anatomy of the local economy. For example, the Dow Jones in the US is completely independent of the stock prices in NSE’s NIFTY. Hence, investors should not be influenced by volatility in international markets, there may be various factors that could affect these stock prices.

5. Don’t rush to invest in volatile sectors!

An important rule for investors is to study trends in the market before investing. If there are particular stocks that drive bear markets- avoid these.

A stock that has a financial risk and a low standard of corporate regulations often lead to long-term problems and has a low chance of recovering. These stocks will have short bursts of upward movements but will have a long-term downward trend.

Do a market analysis of the sector you are investing in, if the industry shows a history of high volatility- you should remain of cautious before you invest too much money into it.

6. Don’t put all your eggs in one basket- Diversify your portfolio!

diversification do not put all your eggs in one basket

One of the biggest mistakes an investor can make is not investing in a variety of stocks. If a certain industry shows potential for high returns, it is not a wise decision to invest all your money here. This is because if a certain economic event has a negative impact on the industry- it could result in a huge financial loss for the investor.

It is better to spread your risk and invest in different stocks that are stable, have a strong market presence and good growth potential. Here, even if you face volatility in one of your assets, you have a diverse portfolio of stocks to cover your losses.

An investor looking to reduce their risks and control losses should diversify their portfolio and not invest in too many volatile stocks. Greed can often take over fear and this can prove to be disastrous. Investors need to perform a thorough analysis of the stock market before picking stocks to invest in. If they do not have the bandwidth to do this, they can consult a financial advisor.

Also read:

Follow the tips listed above to help you get through a period of high stock market volatility. While it is important to safeguard your portfolio from the effects of a volatile market, remember the biggest risk is not taking any risk at all.

Measurement Scales Balance Swinging Swing Equality

Is Stock Market Investing a Zero-Sum Game?

One of the most debated questions regarding stock market is that- Is stock market investing a zero-sum game? If someone makes money in the stock market, does it means that someone else must be losing money?

In this post, we are going to demystify this question and try to answer whether stock investing is a zero-sum game or not.

What is a Zero-Sum Game?

A Zero-sum game is a situation where one person’s profit is equivalent to the another’s a loss so that the net change in wealth is Zero.

A few popular examples of zero-sum game is Poker and gambling. In poker, the amount won by one player is equal to the combined losses of the other participants. Please note that there can be two or multiple participants in such games.

Moreover, Zero-sum games are contrary to win-win situations.

poker

Is stock market investing a Zero-sum game?

When it comes to the stock market, the majority assumes that the market is a zero-sum game. After all, the money made by someone should come from a source and most believe that it costs from the other losing participant.

However, this is not true. Investing in stock can be mutually beneficial.

In the share market, trades are based on future expectations and because of the different risk tolerances of the participants.

Just because someone is selling their stock, doesn’t mean he is losing. He might have made substantial profits and willing to book profits. And similarly, if one sells, there’s no reason to think that the next investor can’t profit too. Here, both the parties can be winners.

Overall, a zero-sum game isn’t the right description of investing. As the company expands and becomes more valuable, the stock market can increase the wealth of both the participants & economy over time.

win win situation stocks Is Stock Market Investing a Zero-Sum Game?

Dividends…

An important factor which is invariably ignored while studying the stock market as a zero-sum game is the dividends. As corporations generate profits from the sales, they share a portion of this profits with their shareholders as the dividends.

(There are even cases where the investors get back more money than the original invested amount just as dividends over time.)

If the market was a closed system with just buyers and sellers, somewhere it could be possibly considered as a zero-sum game. However, it is not a closed system as money is consistently pumped into it as dividends by the companies.

Quick Note: The exception to these scenarios are the companies that do not pay dividends.

Also read:

Closing Thoughts

Investing is not a zero-sum game and both the parties can be winners.

Here, the profit for the participants doesn’t come from the stake of losses by other participants, but from the value created by the company. If one sells a stock, there’s no reason to think that the next investor can’t profit too. As long as the business is performing well, the stock will keep on increasing value without anyone losing the money.

Overall, there doesn’t need to be one winner and other losers. Stock market provides an opportunity for a win-win situation for all.