Now that was easy to visualize.

I had a classmate who was fairly irregular to class, spent a lot of time in the school canteen and supposedly even bunked classes to watch the 'matinee'.

How did he manage to pay for all his nefarious activities?

Well, he used to borrow money from a few friends of mine who saved their pocket money.

During the break, I manage to accost one of those friends who had lent money to my classmate.

"I can understand why Ramesh (by the way, that was my classmate's name) borrows from you. But why do you lend him money? Can he pay back?"

"Look, I don't really intend to spend all my pocket money. I am saving up for a new cycle. Money always burns a hole in my pocket. Hence, I lend it to him," he answered.

"Ramesh has a rich father, who is a family friend," he explained. "I know that I can get my money back. Ramesh also knows that when he turns 18 he will look after his family business and earn well. And then he will have no time to have the fun he is having now. Hence, he borrows to spend," he added.

Learning for me again

'Saving' is not consuming everything today and leaving something for tomorrow whereas 'Borrowing' is consuming more than what one has today, expecting to save more later to pay up for the excess consumption now.

While 'saving' is being conservative and wise, 'borrowing' is being risky and foolish unless for a basic need. Hence, it makes sense to borrow only when one is sure that in the future he will be able to save enough not only to pay up for his borrowings but also to see him through the days when he cannot earn.

But you must listen to this one. My dear grandpa used to buy 10l of milk for 50p and 40kg of rice for Re1 a good fifty years ago! 

Don't believe me? Then sample this. In those days, there were coins of 1p and even less! Incredible, eh? But I have seen those with my own eyes in my father's collection of old coins.

What more, I also remember seeing and transacting in 5p and 10p coins in my childhood. Alas! my son won't get to see those currencies. Except in an collection of old coins perhaps! 

Wondering why I am rambling about 1p coins and getting into the generation business? 

This is not a "Kal Aaj aur Kal" story. Or maybe it is. 

If you have an eye for detail you will have noticed the common thread that runs through these anecdotes. The point that I have been trying to make is how expensive things have become over the years. 

My grandfather used to buy 40kg of rice for Re1 and today a kilo of rice costs Rs20! 10l of milk cost 50p in his days but today you need at least Rs120 to purchase the same amount. 

See what the passage of time has done. It has eroded the value of money. Having Rs800 today is equivalent to having Re1 fifty years ago! 

Economists call it a decline in the purchasing power of money. Remember we encountered this term while getting acquainted with saving, borrowing and investing? The 'purchasing power of money' is the amount of merchandise that a unit of money (say a rupee) can buy. 

And the term 'inflation' has its roots right there. When the purchasing power of money dwindles with time, the phenomenon is called 'inflation'. This is manifested in a general rise in prices of goods and services.

Onions are an integral part of any food preparation in our country. Can you think of having a meal without having a dish that contains onion? Why, onion and chapattis constitute the staple diet for many people.

Let us assume the onion crop fails in a particular year, for whatever reasons.

What happens then? The supply of onions in the market drops. However, people still need onions. Inevitably, the price of onion shoots up as people scramble to buy the limited supply of onions. 

Remember November 1998? Such a situation actually happened in several parts of the country.  It nearly brought down the government! The price of onions rose to as high as Rs40 per kg or  more. 

But how does a simple thing like a one-off drop in onion supply cause prices to rise across the board in sutained fashion?. 

In the winter of 1998, the dabbawallas and restaurants were forced to hike their prices in response to the rising prices of onions. Even your local barber and maidservant demanded a higher pay to meet their higher daily expenses. All thanks to the (mighty?) onion. And this  set off a chain reaction. 

Hence, some of you decide to use more of garlic to make up for the lack of onion. The demand for garlic goes up. A few who eat raw onions decide to substitute it with more of tomato and cucumber. The local sabjiwala senses this shift in consumption happening. The smart businessman that he is, he hikes prices of all vegetables. He starts earning more money. Now his children demand that he should get them a new 21" TV with 100 channels.

And with all sabjiwalas rushing to the nearest TV shop, the sales for TV picks up. The TV company makes more money. Noticing the ballooning profits, the employees of the company demand a hike in their salaries. You are lucky to be working for one such company. You have more money in your pocket. And you have always wanted to buy a car...

We could go on and on, but you get the idea,don't you? The price rise is here to stay. Any guesses on who actually benefits and who loses from this rise? Can 'inflation' lead to prosperity? 

We are posing a lot of questions. Do not worry we will come back to answer them later. Write in at school@sharekhan.com to tell us. Maybe we will use your response itself!

But, for now we just need to understand the concept of inflation. After all, the main objective is to figure out how inflation affects the three friends we met last time - saver, borrower and investor.

Last time we understood how important it is for all of us to save. We all need to save for the day when we will not be earning but will still need to spend money on food, clothing and the occasional movie. 

What would have happened if my grandfather had saved a rupee fifty years back to buy rice now? Oh boy! It would have been a total rip-off. He would receive a few grains of rice in exchange for that amount.

In short, inflation is one BIG enemy of savers.

A good and important question. But we will come back to it later. We need to find out how this monster they call 'inflation' impacts our two other friends.

We have already discovered that 'borrowing is the opposite of saving'. So if the saver is losing, our borrower must be winning.

Yes, of course. After all, the borrower borrows to spend today and repay later. Imagine if my grandfather had saved a rupee fifty years ago and my grandfather's neighbour had borrowed it from him. The neighbour could have bought 40kg of rice then and had a feast. In case he repaid the money to my grandfather now, all that my grandfather would have been able to buy is a few grains of rice!

To top it all, the borrower spends NOW and adds to the inflation effect, doesn't he? And compounds the misery of our saver.

What about our last friend, investor, the slightly difficult one to understand? 

Imagine once again (just one last time, we promise) that my grandfather's friend had invested a rupee in a paddy field, that is bought a paddy field with a rupee. The smart guy would have been raking in money today, selling a kg of rice at Rs20! 

Our investor friend seems a lot better off than even our borrower who benefits from inflation.

No wonder investing is always considered as a good thing to do to beat inflation. It is what textbooks call 'hedging inflation'.

Hey, but what is happening? Last time we understood that the saver, borrower and investor are good friends who complement each other. The saver meets the needs of the borrower and the investor. Life is in perfect harmony.

Now you are saying that 'inflation' upsets this balance completely. That the 'saver' is at a complete disadvantage while the other two benefit from this poor guy.

Is life so very unfair? Should we all stop saving? Or have we missed something very fundamental?

Well, life is never unfair. We have a leveler who comes to the aid of the saver - interest.

Next time, we'll discover how interest offsets inflation and puts our saver on an equal footing with the borrower and the investor. 

1. It does not make sense to save if you have not been compensated for Inflation.
2. In order to boost your saving instinct, you need to be compensated at least for the loss of your purchasing power. That is you need to be compensated for Inflation.

In our examples, we have seen that a borrower is willing to repay a higher sum in order to compensate the lender for the loss of his purchasing power.

I am now wiser. Wise enough to encapsulate all of this into my own saying - 'It is not how much you save but where you invest it that counts' - Sharekhan circa 2000.

By the time you get to this point in the write-up, you may be feeling just a wee bit nervous about your savings. Nay, Investments. Don't. At the end of the day, Investing your Savings is like falling in love. It can be risky and it can hurt, but that doesn't stop us from falling in love does it? For the heady and glorious experience....

The old adage, "its better to have loved and lost than never to have loved at all" may assume a new meaning.

A farmer in remote Bihar borrows heavily from his zamindar to pay the dowry for marrying off his 11-year-old daughter (an extreme form of debt that we know will turn the farmer into a bonded labourer forever).

A newly married yuppie buys a car, TV, fridge on his credit card?(another form of debt that the yuppie hopes to repay with his zooming salaries).

In these instances we see that ?debt? has been incurred to spend beyond one?s current means. We learnt last time that typically whatever we earn either goes into buying food, clothes, or assets like a TV, car, etc. Or we save with the intention to use our savings during our retirement or buy a house, etc. In other words, we spend our earnings today or save it to spend it later. ?Debt? brings in a third element?while we postpone consumption when we save, we spend future savings when we borrow! In simpler terms, ?savings? and ?debt? are like day & night?they can never exist together unless it is twilight. Take the case of Nagesh, who we met up with last time. Nagesh is a very practical person who has learnt from the tough times in his life. Nagesh, just like any other human being, has dreams of buying a car, a big house for his family, but realises that he will only be able to get there in stages as his current earning capacity is too limited. He has been keeping his desires in check while continuing to save regularly and investing a part of it in shares of good companies. Nagesh bought a car last month by selling part of his holding in Zee Telefilms (about 100 shares @ Rs3500 that he had bought over a year back @ Rs100).

Manish has been Nagesh?s colleague for the last four years. Manish believes in living life king size. In his very first year he exceeded the credit limit on his credit card. He has been paying through his nose, shelling out interest at 3% per month on his credit card outstandings. Two years back, he availed of a car loan to buy a Maruti 800, at a monthly installment of Rs8000 when his post-tax salary was just Rs14,000! Last year, envious of Nagesh?s newfound wealth in shares, he decided to dabble in shares too. His broker recommended Blue Information Technologies Ltd. as a hot tip that would double in 3 months? time! Full of fervour, without even checking the background of the firm, Nagesh pledged his wife?s gold and borrowed to buy this stock at Rs150. A week later, he discovered that the stock had fallen 35% from his purchase price. When he called up his broker, he was aghast to find out that the stock had been suspended. His interest meter was ticking on the money he had borrowed while his principal was down the tube. Talk of the power of compounding!

Moral: Never stretch borrowings to invest in the stock market. Shares are long-term investments that cannot be matched with short-term borrowings. Ideally, one should repay all borrowings and then invest the surplus in equities. So, when we are debt free, we are ready to invest in equities! By the way, one is never too old or young to invest as long as one understands the investment one makes.

OK, we have understood that in the long run equities offer the highest returns. We have also learnt that one can invest in equities any time provided one has surpluses after repaying debt and meeting one?s expenditure! But how much do we invest?

How much depends on two criteria. One, the risk profile of the investor and two, the liquidity requirements of the investor! Now that we know Nagesh, his father and friend Manish well, let us understand this better through their actions.

Risk profile! Yes, let?s face it. No equity investments are free of risk. There is no such thing as a free lunch, mind you! There are a whole basket of risks to contend with and we will understand all of them very soon. For now, we need to appreciate that there are risks of losing. Looking at our three personalities, we can straight away rule out Manish. He can?t afford to take any risks as he is buried deep in debt and can?t afford to lose a penny! Nagesh on the other hand is just 35 years old and has a long bright career ahead of him, so he can afford to take greater exposure in equities and in slightly risky shares too (for instance, some stocks from our ?Emerging Star?, ?Ugly Duckling? and ?Vulture?s Pick? categories). Nagesh?s father, on the other hand, has retired and has no source of income other than the savings he has amassed. So he will be able to afford very little risk. Hence, he should be looking at stocks in our ?Evergreen? or ?Apple Green? categories to choose his investments (which is why, if you remember, Nagesh had suggested HLL to his father).

Let us now move on to liquidity. Liquidity requirements signify the need of cash to meet one?s payment obligations (and don?t have anything to do with human beings? fluid intake). Manish needs all the money he can get as he has to meet so many of his loan obligations. Nagesh on the other hand has an idea of his monthly expenses so he has a better fix on his monthly cash requirements. He also needs to maintain a certain amount of cash in liquid savings (savings bank deposit, etc.) just in case there are some unforeseen medical expenses to meet or an unplanned visit to his father?s place. Beyond these requirements, he can look at investing in equities. Nagesh?s father, on the other hand, has to meet his entire expenses from his savings and would have large requirements for immediate cash. Hence, he can allocate a smaller portion of his savings to invest in equities.

Judging the actions of the small world of people we know, we have realised that risk profiles vary with age, current financial position, even one?s own personality. Liquidity requirements too depend on similar factors. These two criteria will be different for different people, but one should not lose sight of one?s risk profile and liquidity requirement while investing in equities.

Next time around, we will try to understand what we buy when we buy equities!

So what we now need to figure out is how to evaluate which company to buy. I?m afraid this is where all those fancy sounding valuation tools come in? PE, RONW, ROCE, EVA, etc. Hey, hang on, it?s not as bad as it sounds. Stick around and we?ll demystify all the above in a jiffy.

But before you get into the complexities of the various valuations tools you can use and how you calculate them, we must table a fundamental principle:

?Investing in equities is akin to owning a business.?

Let?s now explore the full ramifications of this principle.

When you put your money in a bank deposit, you take a risk (albeit small, depending on which bank). In return, you get paid a small interest.

The bank takes on a higher degree of risk and lends that money at a higher interest rate to some businessman, or to a credit card holder who wants to buy a diamond ring for his wife. The bank pays your interest out of the money he earns from the businessman. Or the doting husband.

Whereas, when you buy shares in a company, you are not lending money to the company. By providing capital for the company, which is represented by an equity share, you are participating in the ownership of the company. Clearly, your risk is much greater in this case. Because, in this case, you are entrusting the company with the job of managing risk for you.

Relatively, the risk in lending to a bank is limited. For one, most of our neighbourhood banks are nationalised. So bank deposits are perceived to be backed by the government. There is little soul searching to be done as to which bank to choose. Even in doing so, the highest priority is accorded to a Nationalised Bank purely on the safety parameter. Obviously, when you invest in equities, even this notional sense of security, of a government standing guard over your money, isn?t available to you.

?I put my money in NSC, post office schemes; they double in seven years!? (By the way, HLL in the last seven years is up seven times!!)

?I am too lazy, I leave my money in term deposits with the bank!? (Certain to retire as a pauper!)

?I am clever, I keep deposits with finance companies and co-operative banks. I make upwards of 20%.? (He forgot to mention that a few of them are like CRB! Forget the returns you will not even get your principal!!)

A very rare response would be: ?I invest in equities. I bought Infosys @ Rs500, Zee Telefilms @ Rs220?? (Anybody cares to do the sums for him?!)

Equities, or shares as they are popularly known, have been an enigma for most people. A majority of the middle class in India considers it akin to gambling. A majority of the rest is fascinated by the volatility and the short-term money-making opportunities and misunderstand equities to be a ?get rich quick? scheme. There are very few people who understand that equities offer the highest returns in the long run, adjusted for inflation or even otherwise. Take the case of Nagesh...

Nagesh has had a very conservative upbringing. However, he moved out of his home to pursue his higher studies and his eyes opened! He has been working with a leading MNC as a marketing manager. He has been wisely investing in shares for the last five years, relying on his broker?s advice after doing his own homework. On the other hand, his father worked all his life in a PSU and put all his savings in NSC and Life Insurance. He has retired today and has just realised that all his lifetime savings cannot help him lead a comfortable retired life. Nagesh is now trying to help his father out...

Nagesh: Appa, even now it is not too late. You must invest a portion of your savings in equity. You are getting disheartened because you want to live off the meager interest earnings on your savings. If you put a portion of the money in, say HLL, your money will double in 3 years, quadruple in 5 years!! Appa, equities have the ?power of compounding that is unmatched?.

Appa: Equity is very volatile. After you told me last time, I have been tracking the Sensex on Star News. It goes up two days then there is some political uncertainty and it falls. Sometimes it falls without any reason or otherwise goes up 15% in four days. I cannot handle it. At least here, my principal is safe and I get a fixed return.

Nagesh: Appa, if you use the same Sensex as a benchmark, then the index was 1220 in September 1990 and currently trades at 4800 in September 1999, up four times in 9 years! Even if you had put in money at the height of the market frenzy in 1992, you would have still made money. The market benchmark is just an indication; the concept is to invest in specific good companies. Think Company, Appa, and don?t let the short-term market volatility scare you! In September 1990, HLL was trading at Rs115, while it trades at Rs2500 levels now! 22 times in 9 years!!

Appa: Even then, why put my savings in risky equities?

Nagesh: An equally important thing to understand is: ?Why does one save?? One saves because the productive span for any human being is a small portion of one?s entire life. I may live for 80 years but I can only work between the ages of 24 and 60. Hence, it becomes important during our productive lives to earn surpluses and save them for the period when we can?t be productive and earn. Having said that, Appa, you would also recognise that it is important to retain the purchasing power of our savings. In other words, we all know that we used to purchase grains at Rs2 per kg 5 years back, while we pay Rs10 per kg for the same now. The price will keep on increasing as the population living off a fixed area of land increases. Hence, it is also important that whatever we save now at least fetches us an equal quantity when we retire...have I lost you?

Appa: No, I was just thinking. You are right. I deposited Rs10,000 seven years back in NSC and I just got Rs20,000 now. Seven years back, I used to get vegetables for Rs25 and it used to last for a whole week and then we were four of us. Today, I buy vegetables for Rs100 and it barely lasts for a week though there are just the two of us!

Nagesh: Exactly. That?s why people used to buy gold and land to protect their savings from inflation. However, those were the days when communities were small and agriculture was the only activity. As population grew, needs grew and there was a compelling need to improve efficiency. Hence, factories came up to exploit economies of scale. To cut a long story short, investment in productive assets is the best way of preserving savings and creating wealth. Equity is the most productive asset.

Appa: What is the connection?

Nagesh: Equities or shares represent ownership of businesses that own productive assets like plant & machinery and intellectual capital to produce more goods. On the other hand, when you put money in deposits or lend directly, the money ultimately finds its way to purchase productive assets as companies borrow to fund their business! Just like we save to take care of our retirement, productive assets are created to meet greater demand for goods in the future, because of increasing population and its ever increasing needs. Who ever borrows to fund the asset hopes to make more money on his equity than what he pays for on his borrowings. So, savings in deposits or any other fixed income instrument is sub-optimal! Hence, intuitively too, equity has to make lots more money in the long run than any deposits, because there will be no borrowings if the equity owner realises lesser money!!

Appa: All that is fine. But some companies don?t do well?

Nagesh: Obviously they are risky as certain businesses find the going tough. But collectively, they are not only very essential but very profitable. Hence, the returns on equity are always higher to compensate for the additional risk. Risk is a part and parcel of life. There are so many bus, rail and two wheeler accidents, but that doesn?t mean that we prefer to walk everywhere. Even if we decide to walk, we run the risk of being hit by another vehicle! One should only take care to invest in the right businesses, which have assets capable of earning good returns. Hence, these will have to be businesses that have a bright future. Nobody thinks of buying a bullock cart now!...

The discussion went on for some time. Nagesh?s father was last spotted opening an account with a brokerage house. We checked with the broker and found out that he had made his first purchase of equity?200 shares of HLL?at the age of 62!

While reading through the past learning pieces, did you ever say to yourself: ?Such huge returns? Too good to be true. There must be a catch somewhere.? Or did Nagesh?s father?s apprehensions regarding market volatility and concerns over companies faring badly unsettle you? Did our reference to equity risk, ?no free lunch? and risk profile leave questions unanswered? We sure hope it did, because understanding risks associated with equities and learning how to manage them is the key to achieving higher returns from equities. Remember, the most important features of a fast car are the brakes and the steering wheel?not the accelerator! We begin our own humble attempt to understand this monster that can gobble up all our hard-earned returns!

We began by understanding the necessity to invest for growth, the necessity to beat inflation and retire wealthy. Our adventure began the moment we discovered that equities are lucrative. Not exactly! No adventure can be successfully undertaken before understanding the basics.

We figured out that the most important criteria to qualify for the journey is to be debt-free or, in simpler words, how much surplus we have after paying off all our obligations. We also understood a very important concept. Building of equity investments depends on two criteria:

1. Everybody can?t take the same level of excitement (Risk Profile)
2. Individual cash requirement (Liquidity Requirement)

Then came the party pooper?Risk. The outside chance of losing instead of gaining. In our attempt to understand risk, we classified risk into ?Controllable Risks? (also called ?Company Risk? or ?Diversifiable Risk?) and ?Beyond Control Risks? (also called ?Market Risk? or ?Undiversifiable Risk?). Wake up! We know that ?risk? will always exist. Let us learn to tame it.We use a clich?o reinforce an age-old truth: ?Don?t put all your eggs in one basket!? Spread it around so that if one basket were to drop, only a few of your eggs break! Equally important is to decide: ?In which basket do I put my eggs in?? We will take this up in our next leg of preparation. Remember, we hope to make soldiers out of you! Let us understand our monster better?Equity Risk. Try answering this question below. For the uninitiated, ?Long? stands for a bought position in stock while ?Short? stands for a sold position in a stock that is not owned.

Which of these options do you think is very risky? Which one is the least risky?
1. Long SAIL
2. Long SAIL & Long TISCO
3. Long SAIL & Long HLL
4. Long HLL, Long TISCO, Long ACC & Long Infosys

Let us look at all these four choices?
Choice #1-Long SAIL (our PSU steel company). I am exposed to company-specific risks (inefficient manufacturer, bureaucracy...). I am exposed to the steel cycle too (what if steel prices drop 5%?). To top it all I am exposed to the market risk (Vajpayee government?s fall takes the Sensex down 200 points. Want to know my SAIL price? It has hit the lower circuit!) Gosh! I am exposed to every conceivable risk.

Choice #2 - Long TISCO & Long SAIL. Tricky hey! Two biggest players in steel. As far as company specific risks go, TISCO is a better bet then SAIL. So I am better off. Steel sector downtrend affects both of them. However, since TISCO is a more efficient producer, he will do better than SAIL. So I am better off. However, as far as market risks go, both of them get affected anyway. So I am indifferent. Adding it all up, Choice #2 is definitely better than Choice #1.

We have learnt our first key learning. In choice #2 I had two stocks. I diversified. Voila! The risk reduced! So, diversification helps reduce risks!

Choice #3- Long SAIL & Long HLL. SAIL is a steel company whereas HLL manufactures soaps, detergents?products that human beings will always use come rain or shine! These two companies are in different sectors. If the economy or steel sector does badly, I lose out on only one half of my investment! HLL is a well managed company, so I am better off. Hey, I am much better off than my earlier choice. I have split my risks between two unrelated companies and sectors. What about market risk? SAIL has a lot of sympathy with market movement whereas HLL is very stable (People can?t stop taking a bath just because the Sensex has been down for six months! Whereas people will stop buying cars and car companies will stop manufacturing and hence, steel companies will not be able to sell their steel!!)

Choice #3 is excellent!

We have learnt our next key learning: Equity risk is not additive!

SAIL will have a certain risk on its own while HLL will have another one. But if we have the two of them together, then the risk of this basket will not be risk of SAIL plus risk of HLL. Remember, if SAIL is going down, HLL will not be as money flows to the safe stocks. Similarly, when the going is good, SAIL will outperform HLL.

Choice #4 How all of us would give our right hand to own it! All these four stocks are leaders in their sectors. The sectors almost cover the entire spectrum of the market. At least two of them will be doing well. Any guesses on where it stands on our risk spectrum? Obviously, it is our first choice as it is the least risky.

Another lesson: More widespread the selection of stocks, the better diversified and less risky a portfolio becomes. As the number of stocks increase, risk reduces.

All these instances of diversification were able to bring the ?diversifiable risk? under leash. However, there is another kind of diversification that can take care of the more crazy ?market risk?! A combination of long and short positions!!

Long HLL and Short SAIL. What have I achieved?
Let us look at company risks. Since, I hold HLL I own the company risk whereas if SAIL goes bust because of a company-specific risk, I gain because I have already sold it. With respect to market risks, if the market goes down, SAIL goes down more than HLL so I don?t lose money at all! In short, by using this combination I have only taken company-specific risk. A risk that I understand and can control.

These kind of combinations of long and short positions are used to mitigate market risks. Even the uncontrollable animal can be tamed! Market men call this ?Hedging?. ?Futures & Options?, which we will discuss later, facilitate this better.

Now we know how diversification helps reduce risks. Did anyone bother to ask: ?What about returns?? Well, the clever ones among you would have figured out that by limiting our downside, we have parted with a bit of the upside! So there is a trade-off. Achieving the right balance between risks and returns is the key. Laws of nature apply here too??Strike the right balance?. We will try to take up optimisation or maximising returns for a unit of risk very soon.

Mr Savvy Investor had to make a wise choice with just these details.

He calculated the average returns that he expected to make for each company. He had the probabilities associated with each return. Hence, all he had to do was multiply each probability with the associated return and add all of them together. For example, the average return that one can expect on SCC worked out to:

20%*-5%+30%*10%+40%*25%+10%*35% = 15.5%. This way, he calculated the expected returns for these three companies as follows:

 

Do you think the choice was very easy for Mr Savvy Investor? After all, he just worked out that SCC has the highest expected returns.

Think again, for our wise investor has chosen BCC over the others.

To find out why, cast a glance upon the main table again. The returns on SCC can swing from -5% to 35%, an extremely volatile stock indeed, with returns moving in a range of 40% from -5% to 35%. On the other hand, ECC is little less volatile as its returns fluctuate within a band of 0% to 30% - a range of 30%.

Finally, BCC is found to be a relatively steady stock. The worst case return on BCC is found to be 5% although the best case return, at 25%, is less than the returns of the other two. Anyway, this is a comparatively small range of 20% fluctuation in return.

In other words, Mr. Savvy Investor calculated his expected returns for every unit range of return that the stock could swing. A neat approximation to what the statisticians will call 'deviation from the mean'. BCC turned to have the highest return for every unit of risk.

The answer became obvious to Mr. Savvy Investor- BCC was the best investment option.

Of course, he might discover that the risk premium built into the 12.5% return from BCC' investment is not a good enough premium. But that is a different story altogether.

• This premium is forward looking in nature, as it is based on 'expectation' of return.
• Expected returns could vary within a wide range. A higher range of return implies a higher gap between expected return and the actual return, thereby increasing the uncertainties associated with the return.
• We also understood that in case the range of returns from an investment in a stock is very large, then investing in the stock is more risky. However, this was a crude way of pinning the volatility of stock returns.
• After all the more likelihood of stock returns swinging from our expected returns, the more uncertain the actual returns we realise in the future. Look at our example, SCC returns are expected to be 15.5% but the eventual returns could swing any where from a -5% to 35% depending on how cement prices turn out.
• Statistically, the deviation from the expected return is a measure of the volatility of the stock returns.
• It is not enough to select the stock with the highest 'expected' return. It is important to select a stock that has a higher return per unit of risk.

Of course, this essentially explains the concept of 'equity risk premium'. The higher the volatility or uncertainty, the higher the risk premium sought by the investor.

1. Would you think HLL, Infosys and HFCL all went up by 8% each?
   
    
2. If you think that they all went up by different percentages, then which one do you think went up the most?

We have all seen that every stock posts different gains for the same gain in the Sensex. Stocks like HLL do not rise as fast as the market nor do they drop as fast. Infosys on the other hand posts gains higher than the market. HFCL, we are all well aware, moves sharply higher whenever the market moves higher while falling more sharply than the market in the downswings.

In other words, the influence of the market forces is different on different stocks. Hence, we cannot just settle for the risk premium commanded by the market. We need to measure how the market affects a particular stock.

You'll notice it's divided into two broad sections- Sources of Funds and Application of Funds.

Note: We advise that in case manufacturing units where sales are inclusive of excise duty, it is a good practice to deduct excise duty from operating income as well as from expenditure to get a proper feel.

In the case of GE Shipping, by separating the other income from the total income, we find that the company has marginally improved its efficiency. This is not the picture that emerges from a look at the PBT and PAT, which show a continuing slide despite a continuing rise in operating income. Thus, though the slide continues as far as bottom line is concerned, the company has managed to arrest it at the operating level. This, for an analyst, is a very important finding because it tells him that things are not as bad as they look.

The above figures also show, with greater ease, that the real culprits are interest, depreciation and lower other income. A view may be taken that higher depreciation is on account of higher investment in plant and equipment that was financed by liquidating some of the investments and additional borrowings, which in turn have given rise to higher interest. It may gladden the heart of the analyst to know that the company is investing in new equipment and is willing to pay the higher depreciation though it may somewhat mar the bottom line. When the market conditions improve the company may be in a position to take full advantage of the added equipment. This view, however, will have to be confirmed by going into further details.

A 3.5% increase in operating income has resulted in an increase of 1.8% in operating profit, which is much better than the previous year where an increase in operating income of 1.5% had actually resulted in a decline of 11% in the operating profits. An important trend reversal has taken place here.

The next step calls for a slightly detailed study of the income schedules to find out the non-recurring type of income or income from past events. Examples of such items are settlement of old claims, refund of excess income tax, income through renegotiations, recovery of some bad debts which were earlier written off and any other such items. It is true that generally such items are small in amount compared to the main income yet an analyst has to make sure that any distortions due to oversight are straightened out.

Occasionally we also find some windfall items. A company may decide to sell its holding in other affiliated company during a particular year. The profit from sale of such an investment is definitely a non-recurring type if it exceeds average of earlier years. One example that comes readily to mind is of Kirloskar Oil Engines Limited when it sold a part of its holding in Kirloskar Cummins Limited.

For income from earlier years it is a good practice to deduct it from the year in which it is reported and add it to the year to which it pertains. For windfall income it is better if it is deducted from the single year but maintained in the long-term analysis.

Coming back to Great Eastern Shipping we find two items of the type mentioned above in the annual report for year 1999-2000. The schedule for other income shows Rs. 7 Million as 'Doubtful advances written off in earlier year now recovered' and Rs. 42.5 Million as 'Provision for diminution in value of long term investment written back'. As per our discussions, therefore, Rs.49.5 Million should be deducted from the income of 99-2000 and added to the income of 98-99. The corrected values should therefore appear as given below

 

Please note that in this case the changes are in the other income only and therefore the operating PBT is left unchanged.

A securities analyst has to find out the company's ability to generate sales and retain maximum amount out of it. What it earns out of its own muscle power is what is of main interest and the rest is to be treated as secondary. The above format allows the analyst to study this ability. If one considers Sales as the driving pump for the financial system then it is worth our while to know how much is pure water and how much is air out of all that is pumped. Both are useful but one is more important than the other is.

Note: We advise that in case manufacturing units where sales are inclusive of excise duty, it is a good practice to deduct excise duty from operating income as well as from expenditure to get a proper feel.

In the case of GE Shipping, by separating the other income from the total income, we find that the company has marginally improved its efficiency. This is not the picture that emerges from a look at the PBT and PAT, which show a continuing slide despite a continuing rise in operating income. Thus, though the slide continues as far as bottom line is concerned, the company has managed to arrest it at the operating level. This, for an analyst, is a very important finding because it tells him that things are not as bad as they look.

The above figures also show, with greater ease, that the real culprits are interest, depreciation and lower other income. A view may be taken that higher depreciation is on account of higher investment in plant and equipment that was financed by liquidating some of the investments and additional borrowings, which in turn have given rise to higher interest. It may gladden the heart of the analyst to know that the company is investing in new equipment and is willing to pay the higher depreciation though it may somewhat mar the bottom line. When the market conditions improve the company may be in a position to take full advantage of the added equipment. This view, however, will have to be confirmed by going into further details.

A 3.5% increase in operating income has resulted in an increase of 1.8% in operating profit, which is much better than the previous year where an increase in operating income of 1.5% had actually resulted in a decline of 11% in the operating profits. An important trend reversal has taken place here.

The next step calls for a slightly detailed study of the income schedules to find out the non-recurring type of income or income from past events. Examples of such items are settlement of old claims, refund of excess income tax, income through renegotiations, recovery of some bad debts which were earlier written off and any other such items. It is true that generally such items are small in amount compared to the main income yet an analyst has to make sure that any distortions due to oversight are straightened out.

Occasionally we also find some windfall items. A company may decide to sell its holding in other affiliated company during a particular year. The profit from sale of such an investment is definitely a non-recurring type if it exceeds average of earlier years. One example that comes readily to mind is of Kirloskar Oil Engines Limited when it sold a part of its holding in Kirloskar Cummins Limited.

For income from earlier years it is a good practice to deduct it from the year in which it is reported and add it to the year to which it pertains. For windfall income it is better if it is deducted from the single year but maintained in the long-term analysis.

Coming back to Great Eastern Shipping we find two items of the type mentioned above in the annual report for year 1999-2000. The schedule for other income shows Rs. 7 Million as 'Doubtful advances written off in earlier year now recovered' and Rs. 42.5 Million as 'Provision for diminution in value of long term investment written back'. As per our discussions, therefore, Rs.49.5 Million should be deducted from the income of 99-2000 and added to the income of 98-99. The corrected values should therefore appear as given below

 

Please note that in this case the changes are in the other income only and therefore the operating PBT is left unchanged.

A securities analyst has to find out the company's ability to generate sales and retain maximum amount out of it. What it earns out of its own muscle power is what is of main interest and the rest is to be treated as secondary. The above format allows the analyst to study this ability. If one considers Sales as the driving pump for the financial system then it is worth our while to know how much is pure water and how much is air out of all that is pumped. Both are useful but one is more important than the other is.