Chapter 1:
The Nature of the Market
(All about the various animals in the jungle they
call the stock market, and what they all doą )
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Article 1:
Kissa market ka
You have got richer with the knowledge that owning a share means owning a
part of a company. You are aware now that investing in equities helps
preserve and enhance the process of wealth generation. You have also
learnt that investing in equities is not all only about quick and easy
money. ?Khel Risky Hai?. We then discussed how it was possible to make the
?Khel? becomes less risky for you. We discussed how to tame that monster
called Risk. You?ve learnt about the basic tools in an analyst?s
armoury?PE, RONW, ROCE, Enterprise Value?
Welcome to the World of the Informed Investor. You are now armed with the knowledge of why equities are important and how to value them. It?s time we went into overdrive. You are now aware of how to value a stock, but while it all seemed like an intelligent science so far, very often the stock market seems like a mad place.
Is the stock market like the vegetable market?
Well, the answer is NO. In a vegetable market, there are several links in
the chain. The farmer, who grows the vegetables, is the primary seller.
But he cannot reach us, the primary consumers, directly. Between the
farmer and us are several middlemen, each one with his own cut. The farmer
has no idea of the price the consumers (that?s us) are willing to pay and
we have no idea of the price at which the producer is willing to sell.
What about the market for soaps? Is it any different? To an extent, yes. HLL produces ?Lifebuoy?. But before the product reaches you, it passes through the vast network of wholesalers, dealers, stockists, and retailers. Each one pays a different price before passing it down the chain. However, in this case the producer does set a final price that you would pay. But you do not have the option to bypass the chain.
Stockmarket operates at the speed of light
The stock market is different. Everybody, starting from YOU to the
research analyst, the company insider, the mutual fund, the FII and the
trader/operator, participates in the same market . Small wonder that the
market works at the speed of light. In the vegetable market, due to the
presence of several intermediaries, price responds with a lag to
information and events. For instance, if there is a sudden spurt in the
demand for apples, prices will not shoot up immediately. The information
will travel back to the farmer and if there is a shortage, prices will
eventually spiral. In the stock market, price discovery is instantaneous.
Information and events are known immediately given that all market
participants congregate at one place or on one seamless network.
The stock exchange
The stock exchange is where all participants converge to determine the
price of the product, that is, shares. Ownership of a share indicates
ownership of a certain proportion in a company. Imagine a world without
shares?it would be virtually impossible to create a business and then be
able to realise value for it. Shares enable you to separate ownership from
management and allow businesses to be traded in pieces without forcing the
company/business itself to be broken down. To the outside observer and
even to market participants, the stock market often seems to be a place
where no logic works and only madness prevails. But as you continue along
this voyage into the world of equities, we hope to convince you otherwise.
Only fundamentals work in the long term
At the end of the day, it is the fundamentals which determine the prices.
Every investor must understand that the fundamental factors which market
prices reflect are the sum total of perceptions of all the investors. A
seminal work in this context is the ?Rational expectations theory?. Shares
prices discount the future, and only the variability of the outcome drives
prices.
For instance, the market expects Tisco to announce a profit of Rs100cr. If the profit turns out to be Rs110cr, the market will react positively, driving up the stock price. The opposite would happen if the profit is Rs90cr. Nobody in this world knows what would happen tomorrow and, therefore, markets are perfect only to the extent of available facts and information. Markets can never be perfect with regard to their expectations of the future. Many times, company insiders would have information about a particular event and their activity may make the stock price move towards a level it would have attained if the event was known in the market. This again is not knowledge of the future but knowledge of an event that has already happened. However, this information is restricted to only a few people and, from that point of view, it is a past event for the insiders and a future event for others (investors please note that insider trading is a culpable offence in India and other countries). Investors active in the stock market have to look at market-sensitive factors. It can significantly enhance your returns on investment if you carefully play these factors.
Isn?t it all just about money power?
The rules of demand and supply apply to the stock market just like in any
other market. At the end of the day, the price of a stock moves up only if
the demand from buyers is more than the supply. Therefore, in the short
term market participants with huge money power can significantly impact
the demand-supply equation and hence prices. Who are the market
participants? Literally everybody?the institutions (FIIs, FIs, Mutual
Funds, Banks, Corporates), retail investors (You and Me) and speculators &
traders. So sure, sometimes it does appear that it is just those few mega
speculators or FIIs who are the only ones driving prices. But the market
is bigger than just one or 2 of the big boys. Consider: between September
1994 and October 1998 the supposedly big money FIIs pumped in US$6.1bn
into the market, but it went nowhere. The reason: without fundamentals,
the money power is worth nothing. And while your 100 shares of Cadbury
might seem like nothing, think of millions of investors like yourself, all
over the country, and that is quite some firepower.
What contributes to the mood swings
Each of them has a different risk profile, return expectation and time
horizon for their investments. Very often, each of them also has different
levels of information. So the investor who happens to be a shopkeeper may
know ahead of most others that Cadbury?s new ?Perk? variant is taking the
pants off the competition.The fact that the stock market is a congregation
of people with such different characteristics often results in wild mood
swings.
There is the retail investor who might be selling because he wants to raise money for his son?s marriage (these days that happens too, you know). But there is also the retail investor who is squirreling away his savings for the day when he retires and might not have a regular source of income. There is the FII who is buying because Asia is suddenly the hottest market in the world. And there could also be the FI who is buying to support the market under government instructions. Add to it the speculator who has a very short-term horizon?he knows that Badla rates this weekend are going to be high and therefore the market could head lower by the closing today. So, at any given moment, the market trend depends on which of the participants are in control.
Ignore the noise factor
What about events that receive a lot of attention?budgets, political
uncertainty, duty hikes etc? Sure, they have an impact on the market.
But what is their real impact on good businesses (read good companies)?
At most times, it is too negligible to actually impact the long-term
potential of a good business. But almost always, share prices will be
super-sensitive to such factors. So learn to accept that the market is
going to have its moods; but at the same time, learn to ignore them.
What makes this market unique
What makes the stock market so unique is that no matter who is selling
or buying, there is always a person on the other side. In other words,
when somebody is buying, at the same time somebody else is selling.
That is logical, isn?t it? If everybody only always wanted to sell or
only wanted to buy, then no trading would take place. Of course,
trading does stop sometimes when artificial means like ?circuit
filters? are forced by the exchange. It is the liquidity of this
market and the two-way exchange process that makes it unique. Can you
take the vegetables back to the market and sell them? Well, in this
market you can do the equivalent.
We hope this has helped you to understand better the dynamics of the marketplace?who are the participants and how prices are determined.
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Article 2:
Speculation aint a four-letter word Last time, we had mentioned that what makes the stock market unique is that no matter who is selling or buying, there is always a person on the other side. It is the much-maligned traders/speculators who impart this liquidity to the stock market. This week, we delve deeper into the role of a speculator/operator. ?The stock market is a dangerous place because of the
existence of traders and speculators.? My mother used to tell me that the
stock market is not the place for anybody?s hard earned savings. But after
having invested in some good mutual funds a year back and seeing the
returns, she now has a vastly improved opinion of the market. The truth is that in the stock market, everybody has a role to play, whether it be the small investor, the mutual fund, the FII or the much maligned operator/speculator. Why speculators? Let us presume for a moment that the market is devoid of any traders and speculators. Then the market would be devoid of liquidity. In other words, it would be difficult to buy or sell stocks without significantly affecting the prices. Enter the speculator. He is willing to take more risks than your average investor; he is willing to buy stocks with a very short-time horizon?days, even hours perhaps. The speculator knows that daily price moves are as much a function of the daily sentiment as they are a function of the fundamentals of a company. And he looks to profit from them.
To understand this better, let?s peek into a typical day in the life of a
speculator.
Bajaj Auto workers have gone on a strike and the price has fallen 8%. I
bought Bajaj Auto just a week earlier and am starting to feel pretty
sick. But the speculator?he begins to scent an opportunity.
Next morning: I?m heading for the exit?
The next day, the newspaper headlines scream out that Bajaj Auto?s
EPS could fall 3% if this strike lasts more than 10 days. I can
really feel a chill going down my spine. Oh my God! If this stock
falls any further I would be sitting on a loss, I tell myself. But
hey, I am a smart guy. So I?ll sell the stock today and wait for it
to fall another 10-15% and then buy it back.
?while the speculator is moving in for the kill
Things are going according to plan. I place my order to sell at
10:00 a.m. sharp. The stock opens down 2%, but my broker has an
order to sell at the market price and he promptly does so. Guess
many other brokers had similar orders as well and soon the stock
crumbles a further 8%. Now the speculator moves in for the kill.
Fine, Bajaj Auto?s profits may drop 3% if this strike persists
for more than 10 days. But the stock is down nearly 16% since
the news came out. That may be justified if this strike last
longer than 10 days. However, he feels the market has
overreacted and starts to buy gradually at the lower circuit
(the lowest price that the exchange permits the stock to fall on
a day). In the process, he absorbs the selling pressure coming
from some other friends of mine who called me in the morning and
decided that my strategy was very wise indeed.
1.30 p.m.: The foreigner steps in?
It?s now 1:30 p.m. in Bombay; the stock is down only 7% and
only some stray trades are taking place. A large foreign
fund in London, which has been looking to buy Bajaj Auto for
the last 6 months, senses an opportunity. This fund manager
has a 5-year horizon when he buys a stock. As far as he is
concerned, even if the strike were to persist for a month,
the impact on the earnings of the company would be only a
blip over the 5-year horizon he has in mind. He places his
orders for a very, very large quantity of Bajaj.
?and the speculator?s eagle eye detects his presence
As his broker in Bombay starts buying, you can see some
stirrings of life in the stock. It?s now up 2% from its
low. Some more friends of mine think this is a heaven
sent opportunity. When they had earlier reached me for
advice, there were no buyers in the stock. Now there are
buyers 2% above that price. Hallelujah! Promptly, they
decide to follow me and place their sell orders too. Our
speculator is watching the screen and he now senses that
perhaps some other buyer in the stock has emerged. He
offers a large-sized block on the screen (only a small
portion of his total purchase, though). Immediately,
somebody grabs it up. Now he is convinced that there is
a buyer. He promptly buys back the small quantity he
sold and then a little more. He senses the entry of a
bigger fish.
Sometime later: more buyers in the ring
Shah and Sons is a venerable BSE broking house and
has always been positive on Bajaj Auto ever since
the stock traded in its late teens. It has a lot of
clients who bought Bajaj Auto when it was in the
late teens. Having become millionaires thanks to
their investment in the stock, they have complete
trust and faith in the ability of the company to
make it through this strike. Shah & Sons recommends
the stock yet again to its clients, who start to
buy...
It?s 3.00 p.m.: the stock?s recovered?
The foreign fund is an unrelenting buyer and by
3:00 PM the stock is down only 1%, nearly 7%
above its low for the day?which was when our
speculator friend bought his stock.
?and ?short-sellers? are scurrying for ?cover?
Enter the short-sellers. They are the guys
who sell stocks they don?t have because they
think the stock is going to fall. And when
it does, they will buy the stock back (the
jargon is ?covering?). Some of them had sold
the stock yesterday because they expected it
to fall further. They were right. It did.
Some have covered and booked their profits.
But some have not. And now they want to do
so too?might as well take home the meagre
profit we are still making, they say to
themselves. Some of my friends not only sold
their existing holdings of Bajaj Auto but
also went short (i.e., sold stock they did
not possess) as they were very confident
that the stock would drop further. As their
brokers called them with the bad news that
the stock had gained since they had short
sold, they panicked and asked their brokers
to buy back the stock they had sold short.
For them, it is now only a question of
reducing their losses on the short trade.
It?s closing time?and party time for the
speculator
Now the action is really heating up.
With just 15 minutes to go, the stock is
now trading 1% above yesterday. Our
speculator friend had made 9% in just a
day. Meanwhile, some funds which have
been sitting on the fence wondering when
to make their purchases start feeling
left out. They come rushing in to buy.
Our speculator friend decides to cash in
his chips. As these new funds and the
shortsellers come charging in to buy, he
starts to sell. For the next 15 minutes,
the stock is extremely volatile, rising
nearly 4% above yesterday?s close?the
speculator sells all his stock.
Post script: not every day?s as good
It?s not always a happy ending like
this for the speculator. Sometimes,
he can be spotted drinking away his
sorrows late into the night at
Mahesh Lunch Home, in the vicinity
of the BSE. But today he had a good
day (calls for nothing but Geoffreys).
He took a contrarian view (we would
call it a common sense view) and
profited from it. He provided an
exit route for distressed sellers
like me and provided supply to the
few funds who came late to the
party. In the process, he made a
neat profit. But as I said earlier,
sometimes he makes a loss as well.
So that then is the role of a speculator?he provides liquidity by buying when (nearly) everybody else wants to sell, and by selling when the opposite happens. In the process, he matches time horizons as well?my limited time horizon which made me decide to sell with the idea of buying back later, with that of our London-based FII who decided to buy with a 5-year view. He provided the liquidity. He did it because he knows that all the players in the market have different time horizons and expectations. He just helps bridge the gap. After this, I hope you will all have something good to say about the speculator. Mom does! (All characters and events in this write-up are fictitious. Any resemblance to real-life characters and/or events is purely coincidental.)
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Chapter 2:
Understanding Markets Better
(Badla is not the name of a Bachchan starrer.
ItĘs nothing but a leverage mechanismą )
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Article 1:
Allaying the liquidity fears
As an investor, you should welcome 'rolling settlement' with open arms.
But then you would probably ask- 'What about liquidity'?
We parted here last time after raising the specter of a fall in liquidity post introduction of rolling settlement in the stock market. Liquidity is popularly understood in the market as transaction volumes on a stock exchange. However, sometime later, we will understand the true meaning of 'liquidity' and its dimensions. For now, let us stick with the popular notion of liquidity while we take a look at the popular belief that rolling settlement leads to a drop in volumes on the stock exchanges. Since traders who take positions for five days in a normal five-day settlement market account for a good percentage of daily transaction volumes, a logical conclusion would be to assume that those volumes would disappear. But then will the volumes drop at an aggregate level? Will there be no new form of participation, which will add to the volumes? Will new investors not enter the market now that it is a much safer place for them?
Stock markets and Mumbai roads!
A better way to understand this quandary would be to draw an analogy
between the stock markets and roads of Mumbai!
Like stock markets help investors buy/sell stocks to create wealth for themselves, similarly roads help people to reach from one place to another. Travelling in Mumbai by road means spending many a frustrating moment stuck in a traffic jam. Now imagine a day when the autorickshaws and taxis are on strike! This has happened many a times... Here are some numbers to help you understand the situation a lot better. As per the 1991 statistics, there are some 55,000 taxis and 1,00,000 autorickshaws in Mumbai. Mumbai roads can carry a maximum of 2,50,000 vehicles at any given time. Hence, a strike by the taxis or autorickshaws would mean 1,50,000 less vehicles on the road at any given time. A typical question that can arise is will people face problems reaching wherever they need to in Mumbai? Similarly, a stock market participant would ponder as to what would happen to market volumes during a rolling settlement? On the other hand, people who drive their own vehicles will be a happier lot. They would get to drive on emptier roads without watching out for the rickshawallahs flying in from any side onto their paths or for that matter the guzzling smoke of a cab in the front at a traffic signal. Of course, encouraged by lesser traffic on the roads, there are a lot more who would venture to get their vehicles out. The rest would take to the buses. In such a scenario, normally, the number of bus services gets increased. Of course, we have not forgotten the trains that serve commuters very well. Many more might crowd the trains. In short, life goes on and interestingly noise and air pollution reduces sharply! You will find very few Mumbaites who would complain of these days. May be, if the strike continues the city will find better alternatives. But for people who have not seen a cabbie strike in Mumbai, this may seem like the end of the world or should we say end of the road J Hmm! Rolling settlement could keep the autos and cabs away from the stock market. But pollution levels would drop sharply making life a lot better for the investors. In fact, many people (read small investors) would not feel threatened to ride cycles!
Markets always adapt to change
Before we make a case for how this would result in better forms of
liquidity in the market, it probably makes a case to check what happened
in some other stock market when they switched from a five-day normal
settlement to a rolling settlement.
It is interesting to note that rolling settlement has been embraced by most developed stock markets in the world. So, we need not look far away for a good example. London Stock Exchange had a settlement system very similar to ours (or should we say we borrowed it from them). They shifted to a rolling settlement system in July 1996. Check what happened to the volumes of the market.
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Article 2:
Rolling settlement demystified
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Article 3:
Ups and downs of leveraging
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Article 4:
Talking badla with a vengeance
A local brokerage house, round the corner. A big client calls up and
orders the dealer to buy 20,000 shares of ITC and instructs him to keep it
in ?Badla? (?)
A leading stock operator with a big position in one scrip is busy ramping the price on Friday to ?chchapo? a good ?Hawala? rate for his ?Badla? (??) The head of treasury of a finance company has put up a proposal to the CEO to get a clearance to place his short-term fund surplus in ?Badla? (???) A smart trader, noticing that ?Badla? rates have increased in the last two weeks while the market has gone nowhere, decides to sell his long positions and put his money in ?Badla??(????) A leading pink newspaper?s bold headlines read: ...The ?Badla? positions are huge and the market is likely to fall... (?????) The Taj Conference room is hosting a symposium on equity futures. A doyen of Indian equity markets is speaking on ?Badla vs Futures? (??????) ?Badla?...a five-letter word that means six different things to six different people. And we all thought it was what Big B did to the villains who killed his parents in ?Coolie?! We checked with an expert on the subject...
Settlement mechanism
The existing settlement mechanism on the BSE is a fixed 5-day settlement
period that begins on Monday and ends on Friday. The trades for these five
days are aggregated and the net positions at the end of the session are
settled. The participants for any session can be classified into three
categories:
Capital unrestrained
What does a trader who does not have the money do to fund his
transactions? Simple answer?borrow. But how? Borrowing is not simple as
the individual?s credit rating will have to be assessed. Some people
will have access to cheaper money because of some clout, whereas the
rest will get it at exorbitant rates. But the lenders are likely to
insist on a fixed tenure for the loan and steep penal rates for
pre-payment. The trader (borrower) runs the risk of borrowing for a
fixed term to fund equities that are very volatile (we all know the
2-days? upper circuit and 3-days? down circuit routine very well, don?t
we?).
Enter the leveler
The ?Badla session? is a mechanism that is set up exclusively to offset
outstanding transactions at the end of the settlement. It ensures that
the borrowing rates (?Badla?) are market-determined and, hence, fair to
all the participants. The exchange stands between the lender and the
borrower, thereby mitigating the individual credit risk.
The ?badla session? in its original form was
envisaged as a borrowing mechanism at a rate determined by the market.
This happens in a situation when the cash starved traders outnumber
traders who do not possess the stock they have sold in terms of value
(net long position). However, sometimes the ?badla? session also
functions as a ?stock lending? mechanism. This event occurs when the
traders who do not have the stock outnumber the cash-starved traders
(net short position). The lacunae in the system is that it functions at
the aggregate level. As a result, a person might have short sold a stock
but since the market position is net long, he will be paid ?badla? while
carrying forward his short position. However, whenever the market
position is net short sold, short sellers end up paying while the net
long position holders make merry. The charge paid by short sellers is
called ?Undha Badla?...
Traders in need
Let us assume that Harshad buys 10,000 shares of ITC @ Rs950 per share.
After all the innumerable trades during the week, he is still left with
this position. Harshad Bhai does not have money but desires to carry
forward his transaction as he knows (!) that the company will announce a
bonus next week and the stock will fly. Therefore, he instructs his
broker??Borrowmore??to put it in the ?Badla session?.
The provider
Munshiji is a rich merchant with a lot of surplus funds as he pays his
suppliers 15 days after his customers pay him! He detests trading or
investing in equities as he believes that traders like Harshad Bhai have
reduced it to a gambling den. He dreads losing his (?) capital, but the
lucrative yields in Badla are too attractive to ignore. He instructs his
broker??Avenger??to put his funds in badla.
Meeting ground
Friday?s close of ITC was Rs1001, so the Hawala rate for Saturday?s
badla session has been rounded off to Rs1000. Borrowmore puts Harshad
Bhai?s quote as 10,000 shares to offer @ Rs5 per share (the badla
charge) along with the many other quotes for his other clients. At the
same time, Avenger is scanning the screen looking for a good deal for
Munshiji. He spots the Rs5 quote and hits it, without knowing that it is
Harshad Bhai?s quote...had he known, he would have countered the quote
at Rs6 per share! He doesn?t care as he is not lending to Harshad Bhai
directly but to the exchange, which acts as a counter-party for each
transaction.
Satisfaction guaranteed
As a result of this trade, Harshad Bhai has been able to offset his
transaction for this settlement at Rs1000 per share (the Hawala rate)
while opening a new buy position starting Monday @ Rs1005 per share. In
the process, he has paid Rs5 per share (the difference) but has ensured
that he still benefited by ramping the price on Friday to 1,000 so as to
improve his cash flow at least for the settlement (remember, his price
was Rs950, so he still takes in Rs50 for the settlement! Next
settlement, he may have to cough up but then tomorrow is another day!
Ha! Ha!). Munshiji is also all smiles as he pockets the Rs5 per share
for helping to shift positions for one settlement, one week?an yield of
0.5% per week or 26% annualised. For a similar risk profile, he would
have got 0.2% per week or 11% annualised! He has reason to feel happy.
(Bahut hogaya! Next time we will find out more about how those analysts and traders use these badla positions and badla rates to figure out short-term market trends. Then of course, there is a whole new gamut of issues?economic functions of badla, regulatory issues (taming greed) and Badla vs Futures!! We thought it was a simple thing, but it is a book in itself! More of all this soon. Let us digest all this lest we suffer a bout of indigestion!)
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Article 5:
Aur bhi badla- The plot thickens
Last time, we had discovered that the ?badla? session on weekends is
not a boxing match between the bulls and bears in the old unused ring of
BSE?s famed rotunda, where each tries to take revenge. Instead, we figured
out that ?badla? is a system that allows traders and speculators alike to
transfer positions from one settlement to the other by offering a market
determined borrowing mechanism.
We also discovered, by looking at the activities of Harshad Bhai and Munshiji, how the system helps speculators like Harshad Bhai to leverage positions while money lenders like Munshiji get fantastic returns. The interesting fallout of this system is that short sellers get to carry forward their positions too and can earn badla for doing that! We had left an unfinished agenda of learning more about how traders use badla positions and badla rates to figure out market trends and also touch upon issues like ?Badla vs Futures?, regulations and economic functions of badla. We are back to address the unfinished agenda!
A pink paper?s market commentary: ?Market fell as badla rates hit 35%...
So what, you ask? Why should it fall? We decided to check with a keen
market observer, Mr. Shah. He has been around ever since trading began on
Dalal Street!
Mr. Shah: As you would all know, the market is the sangam of a varied set of traders and investors with different views and investment horizons. The market is also an interplay between fundamentals (or the valuations of businesses against visible earnings stream) and sentiment (that factors in future expectations). Let us try to understand how badla captures useful information that can help predict market trends through the activities of my own two sons! Ketan, my eldest son, is a smart trader who has seen me learn the hard way and has gained better insights. Amit, my younger son, is more impressionable and has taken to trading recently, relying on others for tips.
Ketan Bhai smells a bull market...
During the third week of April 1999, Ketan Bhai suddenly became very
bullish. The big brokerage houses were talking of 5000 Sensex level by
March 2000. The FIIs were pouring in money. The government had fallen but
everybody expected BJP to come back. There were reports of the economy
recovering. Ketan Bhai?s eyes turned big with the desire to make lots of
money and retire! However, he had just a few crores at his disposal that
constrained his ability to take big bets. Ketan was very convinced about
his call and desired to leverage his wealth to the hilt. The ?Badla
System? gave him an opportunity to do it too. "Why not," he said!
Badla to the rescue
Ketan Bhai was a smart trader who did his homework regularly. After all,
there are no gains without pains. He pulled out the latest newspaper and
scanned the pages to look at the badla positions. He heaved a sigh of
relief, comfortable with the fact that the badla positions had dropped to
Rs1017cr while the badla rates hovered around 16%. Ketan Bhai did some
back-of-the-envelope calculations. A Sensex of 5000 by March worked out to
a 40% return (Sensex then was around 3500). With average badla rates
always working out to below 30% for a year, Ketan Bhai stood to pocket the
10% spread on one fifth his exposure (remember, traders need to put in
margin money compulsorily plus other ad hoc margin requirements) - a 50%
return for the year!! Ketan Bhai?s eyes popped out. He rushed straightaway
to his broker and bought Grasim, Infosys and M&M.
Amit, on the other hand, believed that this euphoria was short-lived. He felt that FII money was all hot money that would leave in no time. He felt that the sentiment was bad, otherwise everybody would have taken big positions on badla. So, he stayed away.
Market & badla move in tandem
Two weeks went by and there was no let-up in FII buying. The market soared
past 3800 in just over a week?s time. The smarter traders jumped in
headlong, lest they lose out on the rally. Our friend, Amit, on the other
hand was utterly confused. Though he thought that it was set to reverse,
everyone around him was shouting ?Teji? ?Teji? and jumping in. Ketan Bhai,
on the other hand, was very happy with his performance and closely
monitoring the badla rates and positions. The market got past 4000 in this
frenzy. Amit could wait no longer. He called up his broker and asked him
to buy Rs50lac worth of stocks in carry forward position (positions that
are carried forward from one settlement to another through the badla
system).
Market gains too much of fat
The second week of July, the index closed at 4639 levels. The badla
positions (the fat of the market) had increased to Rs1346cr. The broker
called up Ketan Bhai and informed him that the badla rates had shot up to
22%. Ketan Bhai raised his eyebrows on hearing the rate and reworked his
calculation. The market had risen too fast for comfort. From these levels,
the market had almost reached his 5000 target by year-end, an upside of
just 9% whereas if he opted to be the financier, he could pocket 22%!
Ketan Bhai also figured out that with the market having risen so much and
badla positions increasing now, it would need Herculean amount of buying
or some very positive triggers like a landslide political victory, record
monsoons and fantastic results from corporates! Too much of hope! Ketan
Bhai resolved to sell all his stocks on Monday. Amit, on the other hand,
was quite enthused by the index closing and big badla positions. He
decided to buy more on Monday and carry the positions forward! Next week,
the market opened with a bang as everybody rushed in. Ketan Bhai sold
happily and left instructions with his broker to put his money in badla,
i.e., act as a financier. Amit stretched to his limits and bought more
stocks. Ketan Bhai flew to Goa that weekend to celebrate.
The plump market collapses
The subsequent week, the market opened higher. But with everybody having
built positions with a short-term horizon and FII buying reducing, the
market lacked momentum. To add to the woes, the local institutions started
selling. That week, the market closed lower. Amit started twiddling his
fingers before the badla session. The badla rates shot up to 24% while
positions had also increased to Rs1538cr. Ketan Bhai had a big smile on
his face after he heard about the badla rates from his broker. Amit
started losing big time as the market began falling sharply subsequently,
with FIIs also pressing for sales. He had paid a higher badla rate that
added to his cost while the market had come off 10% in absolute terms.
Most traders like Amit rushed to square off transactions in a hurry,
sending the market to 4488 levels. Meanwhile, Ketan was comfortable with a
5500 Sensex level (The same brokerage house was after all talking of 6000
now!). Suddenly, the upside looked better for Ketan Bhai (25% assuming a
Sensex level of 5500 by year-end!). Ketan Bhai called up his broker to ask
him to buy stocks and keep it as a carry forward position. The cycle
continues...
Mr. Shah: Badla offers an outlet for traders like Ketan Bhai and Amit to trade. It provides scarce capital to traders willing to take the equity risks. Thereby, it ensures better volumes and higher liquidity in the market. However, badla can be a double-edged sword, as it can create a bubble in the market that gets crushed. In other words, over-leveraging will lead the market to run ahead of expectations, scaring long-term capital away from the market by skewing the risk-reward ratio. In the process, markets can be fairly volatile. The unfortunate situation with our market is that capital allocation and risk allocation happen together, as there is no futures market! Ideally, cash markets should only serve the purpose of capital allocation, while the futures market facilitates risk allocation through hedging and speculation! Our market is like the Ganga - the holy water is used for all kinds of unhygienic activities!! Mr. Shah?s making sense but he is being very abstruse (abstract!). Let us handle this topic next time.Soon, the chapter on badla will stand closed. Till then, happy badla!!
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Article 6:
Make money out of thin air
A series of statistics carried in the pink dailies scream: "Arbitrage
Opportunities".
A friend of yours working as a dealer in an FII brokerage house is difficult to catch hold of as he is busy doing GDR arbitrage. A big hedge fund that your neighbour works for arbitrages S&P 500 futures and the S&P Index. "Arbitrage! Arbitrage!!Arbitrage!!!" Ever wondered what this arbitrage is all about?
Why not try and learn it from the streets for a change
Mr. Arb King is a smart smalltime vegetable trader operating in the Juhu
(a posh suburban area in Western Mumbai) vegetable market. He is always on
the look out for opportunities to buy cheap vegetables from one place and
sell them at a higher price in the Juhu market for a good profit. One day,
as he was passing through the vegetable market in Santa Cruz (West) (a
neighbouring suburb), he heard a vendor cry: "Tomato lelo, bus chhe
rupaiya kilo".
Mr. Arb King, who was on his way to his uncle's, stood stupefied as he heard the vendor's cry. They must be out of their minds to sell tomatoes at Rs6 a kilo when I sell the same stuff for Rs9 a kilo just a few kilometers away, he thought. He checked around and discovered that almost all vegetables sold cheaper here, but tomatoes were the cheapest. Maybe people here ate fewer tomatoes than did the rich people in Juhu. Anyway, who cared! Our Mr. King was a trader at heart and he instinctively smelt a profit. He had a bright idea. Why not buy from Santa Cruz and sell at Juhu. Purchase, say, around 30kg of the stuff at Rs6 a kilo from Santa Cruz and sell the same at Rs9 a kilo in Juhu, where the rich men seemed to have a soft spot for this particular vegetable. It would cost him Rs180 (assuming he would not bargain for a better price, which he would anyway), and he could make a neat profit by selling at Rs9 per kg (Rs270 per 30kg!) in the Juhu market.
So, what did Mr. Arb King capitalise on?
Mr. Arb King was not well read but he had enough common sense to figure
out that tomatoes at two places not far apart cannot trade at a big price
difference.
Your economics textbooks will also tell you that any two similar goods with the same utility function (i.e. the same level of customer satisfaction) should quote at the same price. What about cost incurred in transporting the tomatoes? Of course, Mr. Arb King needed to factor in the transport costs between Santa Cruz and Juhu. A cab trip was enough to transport his 30kg of tomatoes. The cab trip meant an additional cost of Rs30. Mr. Arab King started reworking his margins. It all worked out to a neat profit of Rs60 per 30kg of tomatoes sold! All for just an hour's work! Mr. King's trading instincts were aroused and he set about making a quick buck.
What happens if the price difference is actually higher?
Smart traders like Mr. Arb King will notice that there is a profit to be
made. Hence, they will buy from the place where the item trades cheaper,
to sell it where it commands a higher price, and make a cool profit from
the transaction.
Better still, if they can negotiate in such a way that they can execute both ends of the transaction at the same time, then, the business becomes absolutely risk-free. Because under the circumstances, they would not need to worry about any price changes that may happen while they are moving from the lower price point to the higher price point. Literally a free lunch. Economics text books will call the above set of actions "arbitrage" - an attempt to profit by exploiting price differences of identical or similar goods, in different markets or in different forms. Ideally, arbitrage is a pair of opposite transactions that take place simultaneously and generate profit with zero risk. People like Mr. Arb King will be branded as "Arbitrageurs" Coming back to our Mr. Arb King. Though a profit of Rs60 per 30kg of tomatoes does appear to be a small amount, imagine if he were to earn such profits every day for a whole year! Do the sums and you will figure out that he would make more than Rs20,000 from nothing! Yes, money from nothing!
Give me a break! Can these profits last for long?
You have a point. Let us see what happened at the Juhu and Santa Cruz
markets once Mr. King started exploiting the arbitrage opportunity.
Mr. Arb King's frantic selling of tomatoes in the Juhu market without much sweat on his brow did not go unnoticed. One of the other traders, Mr. Jealous Guy, caught up with our King's activities. He decided to start the very next day to make his share of profits. No sooner decided than done! He got 20kg of tomatoes from Santa Cruz. In order to wean away Mr. Arb King's customers, Mr. Jealous Guy dropped his price to Rs8.5 per kg. This competition went on for a week, bringing down the price of tomatoes in Juhu to Rs8 per kg. Meanwhile, a vendor in Santa Cruz, sensing the rise in demand for tomatoes, with both Mr. Arb King and Mr. Jealous Guy becoming regular buyers, hiked his price to Rs6.5 per kg. This hit Mr. Arb King's business hard and he saw his profits dwindle from Rs2 per kg to 50 paise per kg. Soon Mr. Arb King walked away in search of greener pastures. In the meantime, Mr. Me Too got into the act too. In his exuberance, he started selling at Rs7.5 per kg. What are the profits up for grabs now? The price of tomato in Santa Cruz was Rs6.5 per kg, making the 30 kg of tomato more expensive at Rs195. The transportation cost stayed the same at Rs30. But at a selling price of Rs7.5 per kg, the realization was just Rs225. So sad! No more profits. At the end of it all, the residents of Juhu got tomatoes at a cheaper price while the vendors in Santa Cruz got a better price for their tomatoes. And the arbitrageurs like Mr. Arb King and Mr. Jealous Guy made hefty profits from their arbitrage, which, in turn, made the market more efficient or a fairer place, where nobody got anything cheaper than anybody else. Like tomatoes, financial instruments like shares, bonds, futures, et al, can also be arbitraged. In fact, it is easier in case of financial instruments as they are very clearly defined. After all, a share of Reliance is the same whether it is listed on the BSE or the NSE or as a GDR in Luxembourg, as it represents the same percentage of ownership in exactly the same business.
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Article 7:
The making of 'Booms' and 'Busts'
We have come a long way in understanding how leveraging works in the stock
market. We have learnt how leverage is a great ally when used well
(remember our double-edged sword?).
In our 'Talking 'Badla' with a vengeance' , we discovered how traders like Harshad Bhai get to borrow funds at rates determined by the market while lenders like Munshiji fund their positions. Our stock market has a great mechanism called 'badla', which allows traders to carry forward their positions across settlements. We have also gone a step ahead to learn how higher badla positions and badla rates pull the market down.
Oh! A lot of questions indeed.
Let us answer all these questions by simulating a market. Academicians
will call this a 'thought experiment'.
We have three people to help us out - Mr. Operator, Mr. Small Fry and Mr. Sucker. Mr. Operator is a seasoned stock trader who has access to information and has a nose for good stories that can generate interest in the market. He picks his stock early, takes big positions in the stock, whips up sentiment in the stock, and actively trades in the stock. He takes all these big chances because he is in it for big money. Mr. Small Fry is also a stock market veteran. However, he is a little unsure of his abilities to take big bets. He keeps track of price movements in the market. He spots any high level of activity in a stock very early and jumps in. He also keeps an eye on Mr. Operator's actions and tries to follow him. Mr. Operator is aware of Mr. Small Fry piggy- backing on him, and always tries to shake him off his back. Anyway, that is a different story altogether. Mr. Sucker, on the other hand, has a love-hate relationship with the market. He cannot resist watching stock prices going up and others making money. He is eager to get a piece of the action. However, he normally arrives just when the 'money making' part is about to get over. He then starts hating the market for losing money on his trading positions. Yet, tomorrow is always another day for him.
Let's get started on the experiment...
In May 1999, there was a lot of hype in the market over pharma stocks.
Indian companies were discovering molecules. MNC pharma companies were
doling out big payments for these molecules...
During those exuberant times, our friend, Mr. Operator was travelling business class to New Delhi. The passenger next to him was Mr. C.E. Om Prakash, head of a pharma company, Example Drugs Ltd. (Neuters Code: EgDg). During the course of their conversation, Mr. Operator got to know that Mr. Om's company had just discovered a new drug.
June 7th 1999 (Monday): Neuters: EgDg 100
Mr. Operator has done some homework. He is very excited about Example Drugs Ltd. He asks his dealers to buy every share available. The stock is quoting at Rs100. He has Rs10lac of capital. There is carry forward facility available for Example Drugs Ltd. and our friend builds up a position worth Rs66.67lac (at 15% margin, the Rs10lac capital can be leveraged). The stock closes for the week at Rs135 (eventually the hawala rate for 'badla'.)
His position is worth Rs90lac now (Refer Table 1). As we had seen in our 'badla'
sessions, the higher hawala rate means that Mr. Operator will realize a
fresh cash flow of Rs23.33lac (the profit on his position). Of course, the
learned ones among you will note that he will have to pay 'badla' charges.
However, in order to simplify our learning, we are assuming that the 'badla
rates' are zero. After all, our objective is to understand how it all
works and not to figure out the amount of money that our friend makes.
June 14th 1999 (Monday): Neuters: EgDg 140
Mr. Operator has had a great weekend. He is back with renewed energy. He decides to use his improved cash flow of Rs23.33lac to build a fresh position worth Rs155.55lac (remember the hawala difference that he pocketed? We suggest you read our previous 'Badla' write-ups to understand how it works). Meanwhile, our friend, Mr. Small Fry has spotted the sharp rise in the share price of Example Drugs Ltd. (EgDg). He, too, has done his homework. As he walks into his office, one of his dealers tells him how he had overheard Mr. Operator's dealer recommend EgDg to another person. Mr. Small Fry rushes to the dealing room to build a position worth Rs6.67lac (He has a capital of Rs1lac to spare for this). The stock closes for the week at Rs165. There are reports that this stock has also been bought by some mutual funds. In any case, both our friends are happy. The higher closing for the week has ensured that both of them have inflows again due to the higher hawala difference. Mr. Operator has got inflows of Rs44.44lac (Refer Table 1)! Mr. Small Fry, on the other hand, has got an inflow of Rs1.19lac. (Refer table 2)
June 21st 1999 (Monday): Neuters: EgDg 171
Inspired by the jump in his company's share price, Mr. C.E. Om has called a press conference to announce that his company is unveiling a new molecule. Mr. Operator is even more excited about the prospects of this stock. He has every right to be as the stock price has climbed 70% in 15 days. He deploys the Rs44.44lac that he made from the hawala difference to build an additional position of Rs2.96cr. His overall exposure to EgDG has gone up to Rs4.1cr. Mind you, he has done that with just Rs10lac! (The 'power of leveraging'?!) Mr. Small Fry has also done the same. He has used the profits of the previous week to increase his exposure in the same stock. The stock closes for the week at Rs180. Not a great jump compared with the previous week's figures, but a gain all the same. Anyway, the inflows from the market have dropped for both. Mr. Operator has got just Rs21.59lac (Refer Table 1) while Mr. Small Fry has got Rs76,859. A disappointing week, but how long can the stock just keep going up?
June 28th 1999 (Monday): Neuters: EgDg 185
The Investors Guide section of a widely read business paper carried a story on Example Drugs Ltd. They have recommended a 'Buy'. Mr. Sucker, our third friend, reads this on his way to work. Everything falls in place now! He has been watching this stock price climb up, and has not been able to figure out why. The rational investor that he is (at least he thinks so) finally finds the reason. He pulls out his mobile phone and calls up his broker to place a buy order. The dealer confirms the trade at Rs185. Mr. Sucker starts thinking of how he will sell this stock at Rs220 on Friday.
July 1st 1999 (Thursday): Neuters: EgDg 175
EgDg Ltd. reported its first quarter results. The company has shown flat growth in sales. Profits have dropped... There is chaos in the counter for this stock. Two funds are trying to sell their holdings. Mr. Operator is trying to dump his position. Mr. Small Fry is also caught in between. The stock has crashed all the way to hit the lower circuit. The stock closes for the week at Rs155. For the first time, the hawala difference has turned negative. Mr. Operator has to pay up Rs43.34lac (Refer Table 1). Mr. Small Fry has to pay up Rs1.91lac (Refer Table 2). Our poor friend Mr. Sucker, who had great plans of selling it at Rs220, is left reeling and bewildered.
Can you help him?
EgDg Ltd. is up 55% since Mr. Operator bought it. But, Mr. Operator has
lost money on it at the end of the day. In order to pay up his dues of
Rs43.34lac, he will have to sell his original position. Even then, he will
not be able to break even. Mr. Small Fry has lost his capital. Can you
imagine what will happen on the next trading day when Mr. Operator tries
to unwind his position?
Our simulation had some simplifications. However, it is a very good snapshot of the way speculative 'booms' and 'busts' happen in the market. It also shows at a collective level how leveraging can turn vicious. Next time, we will see how the imposition of volatility margins by an exchange actually helps and protects people like Mr. Small Fry and Mr. Sucker. After all, our friend Mr. Operator is a smart guy. In reality, he foresees events and creates the top himself. But that is another story.
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Article 8:
Taming of 'Booms' and 'Busts'
Last time we conducted a thought experiment to understand how margin
trading enhances the 'boom' and 'bust' scenario. We discovered in the end
that even the savvy Mr. Operator could not walk away with profits despite
the stock (Remember? Example Drugs Ltd. EgDg Ltd) trading higher than his
first purchase price
Did something strike you in that example? The most striking thing about the thought experiment was the obvious cascading affect of leveraging when the tide reverses. However, what could have dampened the fall of the market? Let us start with the basics - after all it was all about leveraging, the same old principle that Archimedes spotted. A 15% margin implied that Mr. Small Fry could leverage 6.67 times. In other words, a trader with a capital of Rs1lac can take an exposure worth Rs6.67lac.
What if the margin got raised to 30%?
In that case, Mr. Small Fry would have been able to take an exposure worth
Rs3.33lac instead of the Rs6.67lac. Hence, the sting of a devastating
affect of over-leveraging in a falling market would have been removed.
Lost a little bit? Let us get back to the example. Last time, we saw how Mr. Small Fry tracked the activities of Mr. Operator and jumped on to the bandwagon. Though he missed the first run from Rs100 to Rs140, he also took the plunge on June 14, 1999. His position appreciated by the end of the settlement as the price appreciated to Rs165. He used the 'havala' cash inflow to take additional exposure the following week. The stock gained the following week too, and our friend increased his position further. We have captured how he increased his exposure in the table below. Of course, for the many of you who ran through it last time, skip it. Table 1
We also saw in the end that the tide reversed, and the stock price fell
from Rs185 to Rs155. Mr. Small Fry got caught in the bind. In the end, he
had to bridge a negative cash flow of Rs2.34lac. In order to meet this
cash deficit, he had to sell his original position.
This wiped out his capital and the profit that he still had on his original position. Even then, he had to mobilise Rs63,000 by selling his family gold.
Now let us add a twist to the tale.
Mr. Regulator has this job of ensuring some semblance of sanity in the
market. He polices the market to ensure that there is fair play too. He
also exercises control over the prime market leverage - margins!
As part of his job, Mr. Regulator had been closely watching the activity in EgDg Ltd. He was getting a little uneasy with the sharp spurt in the share's price - from Rs100 to Rs165 in just two weeks. He realised that this speculation was going a little out of hand. He decided to increase margins to 30% from 15% on June 21, 1999 as the price of EgDg Ltd. ran up sharply to Rs171 from Rs100. He called it the 'volatility margin' as it was meant to curb the unabated speculation. As the frenzy continued unabated, he raised it further to 50% on June 28, 1999. How did it make a difference to Mr. Small Fry? Let us rework the numbers again for Mr. Small Fry Table2
Though the first time Mr. Regulator raised margins, Mr. Small Fry must
have cursed him to no ends. But, he must have had better words to use
when he actually saw the outcome. Since he was unable to take bigger
positions, he did not lose as much when the market dropped. Though he
lost his capital in funding the cash flow gap, he was still able to get
away unscathed. Remember in the previous instance, he had to sell his
family gold to fund the loss of Rs63,000.
Hey, wait a minute. Haven't we all seen that the market falls when the
margins go up?
Why?
The market's sentiment takes a beating as traders cannot take those
bigger positions that they would like to. Hence, that must have had a
dampening affect on prices, in this case, on the price of our good old
EgDg Ltd.
In other words, the price would not have moved like Rs100-135-140-165-171-180-185 and then fallen all the way to Rs155. Instead, it was likely to have moved more like Rs100-135-140-165-175-176 and then fallen to Rs155. How does Mr. Small Fry fare in such a situation? Table 3
Mr. Small Fry takes less of a beating obviously as prices do not rise
and fall sharply. In fact, Mr. Small Fry still walks home with more than
half his capital intact.
We had seen for ourselves how unbridled trading, using leverage, creates 'boom' and 'bust' earlier. This time around, we realised the importance of market regulation. Though Mr. Regulator's actions are scorned by the market, these very actions save the likes of Mr. Small Fry and perhaps prevent Mr. Suckers from getting in.
The other key learning is that trading without a proper game-plan can be
dangerous. When the market corrects after speculative excesses, it does
not even spare the likes of Mr. Operator.
Hence, margin trading can prove to be very fatal unless conducted the right way. In a different forum, we will let you know the precautions to be taken to save one's skin while still retaining a chance to profit.
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__________________________________________________________________________________-
Chapter 3:
Investment Strategies
On the horns of a dilemma: should you time the
markets or be a steady investor?
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Article 1:
Cheap stocks may prove costly
How much can you lose?
Everything. This is the stockmarket, guys...where it is possible to lose
everything. If you entered the market in September 1994, there is a 40%
probability that you would have lost everything by September 1999!
Don't believe me? Read on...
Out of the 3162 companies being traded in September 1994, only 1884 were
still trading in September 1999...as many as 1278 scrips had stopped
trading (vanished?). Interestingly, 1178 of these companies were trading
below Rs50 in September 1994.
Share certificates can turn into wastepaper...
The picture get gory as you put the lowest Re-price segment of the 1994
era under the microscope. As many as 85 of every 100 sub-Par (shares
trading below Rs10) shares turned into wastepaper by September 1999!
This ratio decreases as we move towards higher Re-price stocks. The chart above captures this trend perfectly. As we move from left to right on the graph, the stock prices increase and so do the number of stocks that are still in existence. 69% of all the shares trading between Rs10-20 in September 1994 disappeared from the market by September 1999. Things start looking up somewhat in the Rs20-50 range, with the proportion of 'wastepaper' coming down to 38%.
Data Used
For this analysis, all the companies which traded on September 30, 1994,
have been chosen.
On the other hand, all stocks above Rs500 survived the bear market that reigned at the Bombay Stock Exchange between 1994-1999. The survival rate was quite high in the Rs100-500 Re-price segment as well, with nearly 95% of the shares alive and kicking in September 1999.
Now let's look at the returns
An analysis of the returns on investment over this period throws up a
similar pattern, which is hardly surprising.
Returns over September 1994-99
Low-priced stocks: easy money...or bottomless pit?
Mahesh likes the idea of investing in low-priced stocks. His reasoning is
simple. He believes that the chances of a Rs10 stock going to Rs40 are
higher than that of a Rs500 stock appreciating to Rs2000. So, he feels
there's tons of money to be made in low-priced stocks. As he puts it: "Are
yaar, Satasat Infotec bahut hi achha lagta hai. 7 rupye ke bhav mein kya
khona-downside sirf 7 rupya hai aur upside 100% hai."
Guess what? He's right! Our analysis reveals that the sub-Par (i.e. below Rs10) stocks of September 1994 which managed to survive until September 1999 actually delivered the highest returns among all categories!!
Methodology
Returns of the Survivors
You get the drift, right?
Well, you'll agree with me now when I say that you can lose everything in
the stockmarket.
So, what is the best way to avoid to this? That should also be clear after the above analysis. Look for companies with sound fundamentals. And focus on returns-whether the stock has a low Re-price or a high Re-price is immaterial. Let us learn from the past and start channeling our money in the right direction. Happy investing.
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| Article 2:
Invest steadily | Aug 6 2002 You may not catch every peak and bottom but you can get good returns by investing steadily. What would you wish for if an Investment Genie came to you and granted you a wish. No prizes for guessing?You would like to be told when a stock was at a bottom so that you could buy and make a lot of money when it went up. With this knowledge, you reckon, you can make a fortune without the risk of any loss. But then, you are not Aladdin?and do you really believe that the Investment Genie exists? Back to reality my friend. Don?t lose heart. You can still make money in the market. Want to know how? It?s simple actually?Invest steadily!
Steady investments need little timing
In January 1991, Mr. Orderly developed a habit of investing Rs100 in
Hindustan Lever Ltd. (HLL) stock on the 5th, 15th and 25th of every month.
By September 1999, his investment amount added up to Rs31,500. He decided
to sell his shares on September 30, 1999. The sale netted him Rs170,708.
An impressive 441.93% return on his investment.
Why 5-15-25? Because Orderly likes the number 5. What if he was obsessed with the number 3 instead? He would then have invested on 3rd, 13th and 23rd of every month. And, surprise! surprise! His returns would have been much the same?444.89% to be exact! There?s a lesson here: If you?re planning to invest steadily, don?t worry too much about the timing.
Timing does earn a premium, but it?s not much?
Mr. Timer is somewhat of a genius. He has this uncanny ability of
identifying the lowest level of any stock during a month (?he?s got it
made..?, say friends). Timer also started buying HLL shares worth Rs300
every month starting January 1991. The edge he had over Orderly was that
he could pick the stock at its lowest level every month. Timer also sold
all his stock (worth Rs31,500) on September 30, 1999. He received
Rs180,730. His return? A whopping 473.75%. Impressive! But wait a
minute?didn?t that 5-fixated Orderly earn a 441.9% return on the same
investment? That means, for all his genius, Timer earned only a 31.8%
higher return than Orderly. Considering that we?re talking of returns in
excess of 400% here, and that the investment period was over 9 years, it
doesn?t sound all that impressive now, does it?
?requires a lot of effort and experience?
Mr. Follower is a former employee of Timer. He learnt a lot (he
thought so at least!) about the market and identifying the bottoms and
peaks of stocks from his boss. In December 1990, Follower felt
confident enough to quit his job and start out on his own. He also
started buying HLL shares worth Rs300 every month. He applied the
rules learnt from Timer to identify the stock?s lowest level for a
month. But, the stock market is not governed by a perfect science.
Experience plays an important role in successfully applying any rules.
Due to his lack of experience, Follower managed to identify the
monthly bottoms in HLL for only 6 months in a year. For the other 6
months, he ended up investing at the average monthly price. When he
sold his stock on September 30, 1999, he received sum of Rs171,640.
His return?457.67%.
?and may not really be worth it
Follower earned a 15% higher return than Orderly. And for that, he
took the pains of following the HLL price movement all the
time?trying to identify the monthly bottom levels (and as we read
above, he didn?t do a very good job of that anyway!).
Compare that to Orderly?s effort. All he did was call up his broker on the 5th, 15th and 25th of every month and ask him to buy HLL shares worth Rs100. Now, was the 15% higher return earned by Follower really worth the effort?
Tomorrow never comes
Mr. Waiter is not really an investor (though he does have
pretensions). He spends 5 minutes every morning pouring over the
market pages in the newspaper and noting down the stock prices. He
wants to wait for the stock prices to fall to a bottom before
buying. With this kind of mindset, more often than not he never
actually buys a stock.?all money-making opportunities pass him by.
How our investors rank
There is no real cause for concern if your investment philosophy matches that of Orderly or Timer (or even Follower, for that matter). As long as you pick the right stocks, you will end up making money. But if Mr. Waiter reminds you of yourself?now, that is an ominous sign. It?s time to wake up. If you need guidance, look no further than this very issue of ?Taking Stock?. Scrips like Infosys, HLL, Wipro, Indian Shaving, Pfizer & Dr Reddy beckon. You don?t need an Investment Genie. And you may
not be able to identify the bottoms and peaks?but you?ll make
money anyway. Happy investing!
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Article 3:
Going Steady, Harem Ishtyle Last session, we learnt that timing is not a key factor for making money in the stock market. Sure, the returns do go up when you time as well as Mr. Timer. But then you need to be quite a genius, to be able to time as well as him. If not, I am afraid that it requires a lot of time and effort and even then there are no guarantees that you will be as successful as Mr. Timer. It?s very likely that you might get left out like Mr. Waiter. The key to returns in this market is steady investment. This week we dig deeper into this issue. Let?s see what we unearth.
In defense of timing
Many of you who are in the business of timing the market might not have
appreciated our analysis (of course, being told that they earned only
31.8% more than the steady investors in HLL over a 9-year period hasn?t
exactly endeared us to them!). They argue that HLL is the wrong example to
use for this argument. The extra returns earned by HLL are not high
because the stock?s long-term trend has been in the upward direction, they
contend. They believe that the premium earned through timing is far higher
for stocks that have not been in a secular uptrend (which are more
range-bound).
Is there any truth in this contention? To find out, let?s consider a big cyclical company?Reliance Industries Limited (RIL)?and rework the investment returns of Mr. Timer and Mr. Orderly.
How different are returns on a cyclical stock?
As you read last week, Mr.Orderly had invested Rs100 in HLL stock on the
5th, 15th and 25th of every month since January 1991. Let?s assume that
he had invested in Reliance instead. Then, on selling all his stock
(worth Rs31,500) on September 30, 1999, he would have received Rs63,216.
His return on investment?100.69%.
Assume also that Mr.Timer, that old master at finding the bottoms, started investing Rs300 in RIL every month beginning January 1991. By selling the RIL shares on September 30, 1999, he would have earned a return of 120.89%. So there you have it. While steady investment in RIL over the Jan1991-Sep1999 period yielded a return of 100.69%, timing the investment earned an extra 20.2%.
Mr. Timer did fare better with Reliance
Over the nine-year period, Mr.Timer earned 20.2% more than Orderly on
the same investment. The figure does substantiate Mr.Timer?s argument
that the premium derived from timing a stock is higher for range-bound
stocks as compared to stocks like HLL, which show a long-term uptrend.
If you remember, on HLL, Mr.Timer made a return of 473.75% over the
9-year period while Mr.Orderly earned 441.93%. In other words he
earned an extra 31.82% for his efforts, a measly premium of just 6.7%.
On RIL, on the other hand, Timer has earned a premium of nearly 20% as
compared to Mr.Orderly?s returns.
So -Yes, Mr.Timer did do much better with Reliance than with HLL
What if they take exposure to both HLL & RIL?
No investor keeps all his eggs in one basket. Diversification is the
best ?mantra? of any prudent investor. So, let?s create a portfolio
consisting of both HLL and Reliance.
Let?s assume again that Orderly invested Rs100 on 5th, 15th and 25th of every month starting January 1991, but that he spread his investment over two stocks?Rs50 in HLL and Rs50 in RIL. On selling his stocks on September 30, 1999, Orderly would have received Rs125,527 this time around?an impressive 298.50% return on his investment. Now let?s see how Timer would have fared in this scenario. He would have invested Rs300 per month in an equally weighted portfolio of HLL and RIL over the same period, the difference being that he would?ve identified the bottom levels of both stocks every month. His investment would?ve earned him a return of 321.55%. What does that mean? Well, the bottomline is that Timer, for all his expertise in timing, ends up earning a premium of just 7.87% over Orderly?s returns. A measly 7.87% for all that effort!
How do things change in a diversified portfolio?
Obviously, in real life any long-time investor can be expected to
have at least 10-12 stocks in his portfolio. For the purpose of
diversification, let?s assume that these 10-12 stocks will be of
different kinds. Some would be like HLL, an Evergreen stock, and
some would be cyclicals like Zuari where there is much more money
to be made by timing. In other words, the contribution of timing
in such a portfolio would be somewhere in between the two
extremes, perhaps to the tune of the premium earned by Mr.Follower
(remember him?).
In a good and managed portfolio, however, the timing factor gets marginalised. In such a portfolio, the returns earned by Orderly are likely to beaten by only the slimmest of margins by Timer. And in real life, because we often fail to catch the bottom (like Follower), there is a big risk that we could end up with money in our bank (like Waiter) even as the stocks we want continue to gallop higher. The key to making money in the market with
the least amount of effort involves just two simple steps. First,
and the most important, is steady investment. The other is
investing in a portfolio. By following these two steps, you will
not only make money but your returns could even match those of Mr.
Timer. Happy investing!
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Chapter 4:
More on Valuing equities
(Beyond PEs & PEGs- climbing the ropes of
equity valuation)
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Article 1:
Of cash flow discounting
Here is a small recap for all of you who have missed our earlier school
articles on investing and time value of money.
Investment is essentially a matter of putting your savings into an asset (bank deposit, bonds, debentures, shares, real estate etc) with the expectation of receiving a larger sum in the future. Since the future is not certain there is risk in the investment for which investors will wish compensation through time value of money. That makes intuitive sense, doesn't it? Lets try a small quiz. If you invest today, a sum of Rs.100 in a post office at the rate of 10% compounded annually for 2 years then how much cash you will receive after two years? What? You said very simple! And your answer is Rs. 121. Brilliant! Now, lets try a tricky one. If the same post office promises you to pay Rs.121 two years from today and the rate of interest is same at 10% compounded annually then how much money he will ask you to deposit? Yes, you got it - it is the same Rs. 100. But let us check the science behind it. As you know, Rs.100 today is worth more than Rs. 100 tomorrow, because of the inflation and the investment risk i.e. the risk you take in investing this Rs.100. This is called the "Time Value of Money" In our example above, Rs. 100 that you deposited in the post office is your principal investment. The interest rate of 10% is the "time value of money". When you answered Rs.121 as the money you will receive after 2 years, you added the time value of money to your original investment. But when you know the amount (cash flow) you will receive after two years then you need to remove this time value of money from that amount to get the fair price, also known as present value, you should invest. This method of finding the present value is known as Cash Flow Discounting and the time value of money is called the discount factor.
Cash flow discounting is the backbone of all financial analysis. Why?
All project decisions are based on the cash flow discounting. As a matter
of fact, this cash flow discounting is the prerequisite that must be used
in the decision of every penny spent by a corporate. For a corporate, the
time value of money is the cost of their capital (a topic that we can
discuss in detail some other time). Now lets check how a corporate uses
this concept in its decision making process with a simple example.
Should we upgrade the computer?
A large manufacturing firm is considering improving its computer facility.
The firm currently has a computer that can be upgraded at a cost of
Rs20000. The upgraded computer will be useful for 5 years and will provide
cost savings of Rs7500 per year. The cost of capital (time value of money)
is 15%.
Should the company spend Rs20000 in upgrading the computer?
If the company decides to upgrade, it will save Rs7500 every year for next
five years. But the money has to be paid today, so the company must decide
today whether it makes financial sense. So it needs to find what the
saving is worth today - i.e. what is the sum of the present value of these
savings in each year. Does that sound complicated? How it will do it? Just
apply the above science of Discounting Cash Flow. Saving in year 1 (Rs.
7500) will be discounted by one year discounting factor, saving in year 2
by two years discounting factor and so on.
Similarly, you can calculate for third year as Rs4931, fourth year as
Rs4288 and fifth year as Rs3728.
By adding the present value of all these savings you can get the present value of the total saving by computer upgradation in five years as Rs25140. The total cost of the proposed project is Rs20000. Hence the company can save a net of Rs5140 by undertaking the upgradation. This net value of saving is known as the Net Present Value (NPV). So here is the conclusion from the example. If the NPV of the project is positive then go ahead with the project and vice versa. (and if companies go ahead with a project with a negative NPV - well, what can we say -that is throwing good money after bad!) The story of project selection does not end here. When a corporate makes an investment decision, it may have an array of options or projects that they can undertake. As a simplistic example, if Reliance were to decide to spend Rs 200 Cr in increasing their polyester fibre capacity, they may compare it to acquiring an existing unit, or even with an altogether different project such as spending the money in the refinery or the jetty or a telecom project instead. . For all the options, the corporate will project the future cash flows and then calculate the net present value. One of the key tools in the selection of the project would be the one that yields the highest NPV.
But this is how companies take decisions. How you I use this NPV as an
investor?
As an investor, you can use this discounted cash flow analysis for
comparing the investment opportunities and selecting the better one. You
decide your investment horizon, and calculate the possible cash flows from
different investment options within that period of time. The option with
the highest NPV represents the best investment worthy option.
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Article 2:
Return on net worth
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Article 3:
Cost of Equity -- it's for real
" ...we prefer equity to debt
as it works out cheaper for us..."
-promoter of a company that raised money in the 94 IPO boom Nothing could be further from the truth. It's true that, unlike debt, there is no fixed cash flow that a firm must compulsorily give to its shareholders on a regular basis. But that in no way means that equity is cheap. In fact, equity has a cost and the cost is real.
Dividends and its offshoots
Dividend payout is the most visible cost, as it represents a company's
cash outflow to shareholders every year. By the way, dividend is defined
as the distribution of earnings to shareholders during a year.
For a minute, let us assume it is dividend that is cost of equity
A company normally announces dividend as a percentage of the face value of
its share. Hence, when HLL says it is paying a dividend of 290%, it
actually means that it is paying a dividend of Rs2.9 per share (remember
the face value of HLL is Re1 now)!
But don't we pay Rs215 to buy a share of HLL? So we earn Rs2.9 on Rs215 that we invest! That works out to 1.35%. Incidentally, this is called 'dividend yield' What? For bearing all the risks associated with equities we get less than a savings bank deposit return? Are we missing something? Of course we are...
A few steps back before we take the big leap forward
Right at the beginning, we discovered that the investor has his eye on the
big stakes. He is willing to risk his capital today in an investment that
he believes will earn him returns over the life of the business. He
believes that in future such an investment will yield much superior
returns to that of a debt investment.
Hence, the price of the stock at any given point in time is the value that is placed on the expected future stream of dividends from the business over its lifetime. So when you sell a stock you are effectively selling the right to future dividends that you could have earned from the stock.
Now, does current dividend indicate future dividend flows?
No. This is because dividends in future are expected dividends. The actual
dividends might be higher or lower, depending on profits for that year and
the profits the company wishes to plough back into its business to earn
higher profits in future years.
A small aside -- the proportion of profits that a company pays out in a given year is called 'dividend payout ratio'. And the proportion of net profit that it ploughs back into business is its plough-back ratio. Since HLL paid out Rs638cr as dividend out of its profits of Rs1070cr in FY2000, its dividend payout ratio was 60%. So as the company grows in size, enhancing its ability to earn more profits and pay higher dividends in the future, the value that the market places on the future dividend stream increases. In other words, the market price increases. We all know this as 'capital gains'. We know that we buy stocks for capital gains but, in essence, we still invest in stocks for the future dividend stream that is captured by the 'capital gains'. In short, stocks are bought for their dividend yield and their capital gains. Thus, the expected rate of return from equity is: Expected rate of return = dividend yield + capital gains Since this is what shareholders expect from their investment, a company has to deliver on these counts in order to service its equity. This is its cost of equity. At this stage, we could take a break to ponder over an age-old wisdom -- Isn't 'A bird in the hand is worth two in the bush'?
Is the present dividend (which is safe) always preferable to future
dividends (which are risky)?
Reliance Industries (has a dividend payout ratio of 17%) has a good track
record of paying dividends. Infosys, on the other hand, pays out only 10%
of its net profit as dividend. Its dividend payout is 10% and plough-back
ratio is 90%. Infosys is held in higher esteem by the market. Why? Infosys
has a return on net worth (RoNW) of 42%. Its net profit is growing at over
80% year on year. If instead of paying out this profit as dividend, the
company re-invests a substantial portion back into its business, then this
capital could earn an additional return next year.
For instance, in FY2000, Infosys ploughed back Rs264cr (that's 90% of its net profit) into its business. This will earn an additional return of about Rs110cr (simply 42%*264) this year even if the company maintains its RoNW. Thus, on this count alone the re-invested amount will yield a growth of 38% (simply the plough back ratio * RoNW or 90%*42%) in its earnings. Now let us work out similar numbers for Reliance. Reliance has a RoNW of 23%. It re-invested 83% of the net profit, that is Rs1983cr, in FY2000, into its business. Therefore, this incremental amount can generate a return of Rs464cr, implying a growth of about 19%. Thus a Rs100 re-invested in Infosys will compound at the rate of 38% while that in Reliance will compound at the rate of 19%. According to finance gurus, Brealy and Myers, "This is because the reduction in value caused by reduction in dividends in the earlier years is compensated by the increase in value caused by the extra dividends in later years." Simply, investors in such high-growth firms are willing to forgo dividends in the early years in the hope of enjoying much higher dividends in future years. As a result of this the stock prices rise. In other words, shareholders are indifferent, so long as a lower dividend yield is compensated for by a higher capital gain.
But how do you calculate cost of equity?
Familiar path that we treaded while discussing "Risk Premium" So Capital
Asset Pricing Model (CAPM) must be the answer.
Thus the cost of equity, ke = Rf + beta (Rm-Rf)
Where ke = cost of equity, Rf = the risk-free premium, Rm = market return. If we plug in the values for HLL in the above formula, its cost of equity works out to 21.9%. So the next time someone tells you that equity is cheap, you know better! A company should earn a return on equity that is at least greater than the cost of its equity. Thus, cost of equity sets an important standard to evaluate the way a company does its business.
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Article 4:
Getting to know RoCE
Assume that a genie appears before you for some bizarre reason. And he
wishes to grant you a boon -- just one financial ratio as a valuation
tool. What would you ask for?
Would it not be the ratio that will help you figure out in one go general
management performance in relation to the capital invested in the
business? Well, what you would be asking for is good old Return on Capital
Employed!
While valuing companies, we are actually trying to measure the return that the company is able to generate. Those companies that earn a higher return on every rupee that is invested are more valuable than those who earn a lower return on a similar investment. Two very popular tools that come in handy in studying returns generated by companies are:
The next question that presents itself is: How are they different? And,
more importantly, which is a better measure of return?
Enter Return on Net Worth
We have met Return on Net Worth before. In all its simplicity it tells us
what, as shareholders, we are getting back from our investment in the
business. And as a shareholder that is what you are interested in.
Enter Return on Capital Employed
Is shareholders' equity the only funds that the company uses during the
course of its business?
Of course not. The company could raise money - and often does - from other sources too, like debt, preference shares, warrants etc. Some even use lease financing. Return on Capital Employed does not discriminate between different types of capital. It compares operating profit (less depreciation) against the total capital employed in the business. Thus it works at a more basic level. It reflects the overall earnings capacity of the business. A small aside: Why does the RoCE take operating profit after depreciation? This is because although depreciation is a non-cash expenditure, it is a payment towards the use of assets. At a slightly conceptual level, depreciation is the amount that a company sets aside to replace its assets in future. After all, every asset has a life and needs to be replaced sometime. Thus depreciation is a real cost of production and must be deducted from the operating profit.
Now that we have heard what each of them had to say...But before we get
into the verdict let us take two examples.
Here is a company, Efficient Ltd. It's business is doing well and it
manages to rake in a neat margin of 35% at its operating level. At the end
of the year, here's how its numbers look in three diverse debt-equity
scenarios.
But before you cast your vote in favour of RoNW, here is the other example
There are two companies operating in the same business - Strong Ltd. and
Not-so-strong Ltd. And here is a glimpse of their financials.
The verdict... a draw!
RoNW gives us the final picture of how a business is performing. To that
extent, RoNW is a good indicator of how much you are getting on your
investment in capital.
But do not stop at testing just how much your capital (shareholder's funds) has returned to you. You must also test if your capital is safe. There are plenty of instances when companies heavy with debt have eroded their net worth over a period of time. Thus, RoCE is a better measure to test the viability of the company's operations; RoNW is better to gauge the returns that you get as a shareholder. In order to get a complete picture of a company's ability to generate returns, one needs to keep track of both these ratios - Return on Capital Employed and Return on Net Worth.
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Article 5:
Economic Value Added
You may recall seeing Economic Value Added Statements in many annual
reports - Infosys (for that matter in those of most software companies),
Hindustan Lever and even Balrampur Chini to name a few.
EVA as a tool for spotting value has assumed a lot of importance these days. But what exactly is this new thing, EVA? And is it important for you as a shareholder? Very simply, EVA is a measure of value that a company has added as a result of its operations during a period of time. And it has its genesis in the same timeless concepts of RoCE and Cost of Equity.
Return on Capital Employed, we saw, is smart in showing the operational
competence (or lack of it) for a company. But it still does not indicate
the "take home" that you get by investing in the business. This is because
something very crucial is still to be accounted for and that is the Cost
of Capital.
Cost of Capital? A business makes use of capital for its operations.
And capital - debt or equity - entails certain costs. For a company, the
overall cost of capital is the sum of cost of debt and cost of equity
weighted by their proportion in the total capital. This is called the
Weighted Average Cost of Capital (WACC).
Now, Cost of Capital sets an important benchmark for the company. This is the least return that it should earn on its capital for its operations to make sense in the first place.
If the RoCE is equal to the WACC, then it effectively means that the
company is worth the initial investment, since it has earned exactly what
it has paid for its capital. It's a 'nothing lost, nothing gained'
scenario - that is, it's a kind of break-even for the shareholders.
Anything that the firm earns over and above its cost of capital is what has been added by way of value from its operations. This simple concept is called Economic Value Added. Thus,
Ultimately, this spread between the
RoCE and the WACC is what the market seeks and values in a company.
This is the very source of capital appreciation. In fact, this is what you
are betting on when you are taking a risk on an equity.
The concept of EVA is not new
Needless to say, EVA has its relevance in any and every business. And
that's the reason for its universal popularity. But while EVA has become a
much talked about parameter, it is not as if it is a novel concept hit
upon only in recent times.
This concept of a business's ability to earn something over and above what it pays for its capital has been in existence for a long time. Way back in 1890, Sir Alfred Marshall, while defining the concept of economic profit, had said, "What remains of his (owner's or manager's) profit, after deducting interest on his capital at the current rate, may be called the earnings of his undertaking."
The EVA way of determining value
EVA is just another way of determining value rather than a new concept in
itself. To get a perspective on the EVA way of calculating value, take the
example of Hindustan Lever.
1. The first step is to calculate the Return on Capital Employed, tax adjusted. Net operating profit less adjusted taxes divided by the average Capital Employed gives the Return on Capital Employed. Aside: Why deduct taxes? This is because, as a shareholder, you are entitled to what is ultimately due to you after paying all possible expenses. And tax is a statutory payment that needs to be paid anyway. Thus for the calculation of RoCE for EVA, we take the operating profit less tax.
EVA and DCF - siblings
EVA does something similar to what discounted cash flow (DCF) does. It
takes the returns from operations and deducts all charges of operations,
including depreciation, and then finally deducts the cost of capital. And
that is what the company has earned for the year.
And what does a DCF do? It finds the free cash flows of the firm over its life after deducting all charges towards operations and financing. Isn't then EVA akin to free cash flow? It is! Now the Net Present Value of these free cash flows (in DCF) give the fair value of the company today. Similarly, can we compute the fair value of a company using EVA? Hmmm... true that EVA is often expressed as a percentage, since both RoCE and WACC are computed as percentage of capital employed. But instead of taking EVA as a percentage, if we just take the operating profit minus taxes and deduct the capital charges, then the resultant is the amount of value added in absolute terms (in crores in this instance). When the stream of EVA over all future years in the life of a company is discounted to the present, then the cumulative EVA will be nothing but equal to the Net Present Value. But what has spurred the popularity of EVA over DCF is that it is a more practical version. It can be calculated for every period and hence is the more handy tool to track the performance of a company.
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Article 6:
It takes two to tango
PE, BV, EV, RC - these alphabets keep popping up in discussions about
stocks and stock markets. If you do not feel at home in the maze of these
alphabets and acronyms, then you might want to take a look at an earlier
discussion - "BV, EV aur RC: The Alphabet Soup of Valuation".
This discussion is devoted to the concept of enterprise value (EV) and how it helps in valuing companies. Enterprise value does just what its name suggests that it does - it seeks to find the market value of the enterprise J. Simple isn't it? But remember that the operative word here is 'market'. The enterprise value at any instant of time tells us the value of the firm as the market sees it. It does not say if that is the fair value of the company nor does it concern itself with the balance sheet value of the company. It says if you were to buy over the company what would you need to pay today. You will need to buy all its equity at its market price. Also since you are buying over the company, you assume the responsibility for all its debt. And finally, the company has some cash and investments that you inherit, and your cash outflow stands reduced by that amount. Thus the Enterprise Value is market value of equity plus market value of debt minus cash and investments. The market value of equity is the current market price of a share multiplied by the number of shares outstanding. This is nothing but market capitalisation. It goes without saying that the market value of equity is what undergoes a continuous change with the change in prices. And due to this component, the enterprise value changes continuously. As for debt, normally, the value does not change. Mind you, during periods of inflation, the value of debt instruments may fluctuate wildly. For firms, however, much of the debt consists of term loans that are unlisted and hence the value does not undergo much change. It is quite fine to take it as shown in the company's books.
What if the company does not have debt, like most software companies? Then
the enterprise value is equal to the market capitalisation...
Take a look at Table 1 -
EBIDTA?
EBIDTA stands for 'Earnings Before Interest, Depreciation, Tax and
Amortisation'. It is the total income that a company has generated from
its operations minus its operating expenses. EBIDTA is also known as the
operating profit.
Instead of 'earnings', some people prefer the word 'profit' and hence EBIDTA is also referred to as PBIDTA. "What's in a name!" as Shakespeare would say. Table 2 shows the position of EBIDTA in a typical Profit and Loss Statement...
Wondering what's amortisation?
Voila!
We have EV and we have EBIDTA. EV tells us the market value of the
company. EBIDTA tells us the operating profit of the company.
Just pause and reflect what they both together tell us.... The next time around, we will enjoy their jugalbandi...
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Article 7:
The missing link
Numerous ways and means have come up to value equities. There is the
favourite price-earnings ratio that examines price in relation to earnings
or the return ratios that deal with profitability of a business. Then
there are parameters that seek to value assets-- replacement cost, book
value and net asset value. Of course, not to forget the queen of them
all-the discounted cash flows.
But the market keeps throwing unique instances that challenge these means-instances that cannot be explained by the existing tools. Thus begins a new learning. And the process of evolution continues in the stock market.
Better than the rest
About two years back, bank stocks typically quoted below their book
values. Their business was cyclical, closely linked to the economic
upturns and downturns and so on. Then came HDFC Bank and ushered in a new
genre in banking. It quoted at a price-to-book value of 8x when the market
leader State Bank of India was at or below its book value. And it has
retained its premium rating to this day.
Dr Reddy's Labs, an Indian pharmaceutical company, has always been quoting a notch ahead of its Indian peers. And in recent times, it has even inched close to the MNCs like Glaxo and Hoechst. Another stock that has defied valuation norms is Reliance Petroleum. Studies of DCF --theoretically the best method of equity valuation--put a fair value of about Rs45. But that didn't deter the stock from reaching up to Rs70 levels, quoting way beyond the other oil refining and marketing companies. Instances of "expensive valuations" are perhaps most common in the technology sector. At the peak in February 2000 (did I hear you sigh?) Wipro was quoting at a price-to-earnings of about 400x. Now after a year, all the techs have fallen by about 70-80% of their peak values but Wipro still trades at a premium to all the listed stocks. I am sure you can recall enough examples where stocks have consistently traded at or over and above their fair value.
That makes one wonder: Why do some stocks trade at a premium?
Is the market blind in love?
History has it that though at times the market is in the grip of blind
frenzy or hapless panic, it has got its sanity restored sooner or later.
Over a longer timeframe the market corrects its excesses.
Then, is there something wrong with DCF as a measure of value?
Again the answer is a clear "No". DCF in all its simplicity and elegance
says that the value of a business is the present value of its future
cash flows. Thus, the stock price should ultimately converge to the DCF
value.
So what is the cause of this gap between market value and the DCF value?
Michael J Maboussin, Professor at Columbia Business School, has
attempted to explain this gap with the concept of "real options".
Real options? What does a company comprise of? It has its current businesses and it has opportunities. Companies get cash flows from their current operations. In addition to that, they have several strategic options that they can explore in future. Here, sample these:
All these are opportunities that exist and are valuable. However, it
is difficult and premature to attribute cash flows to them. This is
because the time span and the plan of action are very uncertain.
But the forward-looking market values these opportunities nonetheless
This is because these opportunities are value generating for the
company. This is the source of the gap that one sees between the market
value and the DCF value. One can bridge this gap by extending the
concepts of financial options to these real life opportunities. Hence
these are called Real options.
A financial option is a derivative instrument called "option" that offers you the right but not the obligation to buy a commodity (say a stock) at an agreed price on a particular date. Similarly, companies have the right but not the obligation of entering into some opportunity during a particular period at a particular cost. Real options can complement the DCF method of valuation. A company can thus be better valued as a combination of: discounted cash flows of its existing business plus a portfolio of real options. For the market sees more than meets the eye.
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Article 8:
Real options at work
(We take our discussion on real options further. Just in
case you have missed out on our first episode on real options, we strongly
recommend that you take a look at "Real Options: The missing link".)
Visualise this company called Great Soaps and Detergents Ltd (GSDL). It has many good brands of soaps and detergents-people across social segments use its products in the farthest nook and corner of the country. Imagine the distribution reach that it must have to cater to such a wide audience! To retain its control over its raw materials, it even has its own chemical facility where it produces linear alkyl benzene (LAB)-the primary raw materials for detergents. The excess of LAB it sells to other users. An integrated player indeed! Its current financials look like this:
The company has the right but not the obligation to exercise these
opportunities. What we are not sure is when or how the company will
utilize them.
Notice a crucial characteristic of real options?
The best part about real options is that it brings in strategy into play and hence makes a more realistic valuation tool.
But before we get carried away by "real options", a caveat is due?
What is the probability that GSDL has the ability to exercise these
options? Taking this question further, does any and every company in the
soaps and detergent segment enjoy these options?
There are some qualities that the concept of real options presupposes.
In fact, real options work best when these three criteria are in place. And these are the very reasons why two companies operating in the same business might not have similar option values.
Now comes the billion dollar question: How relevant are real options in
the stock market?
If you remember the discussion started with an attempt to explain the
divergence between the stock market value and the fair value given by DCF.
There is little doubt that the market values opportunities. After all,
they can generate value for the company.
Implicitly, while talking about stocks we do talk of "potential" for companies. Real options provide a theoretical framework to put a number for what we loosely term as "potential". We will let Maboussin explain the relevance of real options in the stock market. Is it valuing the unimaginable? Yes Is the unimaginable valuable? Yes
As an investor, what are your?well?options?
J
Depending on your risk profile (and hence return expectations), there are
three options that you can take:
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Article 9:
Return on assets Return
on assets (RoA) is a lesser-known sibling of return on net worth (RoNW) and
return on capital employed (RoCE). Rarely will
RoA tells us how much return has the company ultimately earned on every
Re1 of asset that it has. (After all, ability to generate cash flows is what
defines an asset). That's RoA in a nutshell.
Between the two of them, they give a good
perspective of the profitability and capital efficiency of most
companies--whether it makes soaps or drugs or heavy equipment or oil or
cement. Table: Interesting features that distinguish a bank
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Chapter 5:
Investing Styles
(Everything about the groovy styles of investing
in stocks..)
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Article 1:
Of value investing
Should you buy Growth? Or should you buy Value?
You should buy what makes you money said the wise guy. Growth vs. Value investing is one of those debates that have been around for ages now and you can be sure that in the year 2050 the inheritors of your portfolio will still be at it, hammer and tongs. Because, they are two diametrically opposite schools of thought on the way to make money in the stock market. But why re-invent the wheel? Let us first turn to the Gurus who wrote the book on what both these schools of investing stand for.
For Value stocks we turn to Sir John Templeton:
These are stocks selling at substantial discounts to our appraisal of
their longer term, intrinsic value. Generally, we choose solid companies
whose stock is trading at prices that are unduly low in relation to their
value and potential.
And for growth stocks here's the word from the doyen of growth investing,
Mr. Thomas Rowe Price, a pioneer of this approach in the late 1930s:
Growth stock investing focuses on well-managed companies whose earnings
and dividends are expected to grow faster than both inflation and the
overall economy. The real test for a growth company is its ability to
sustain earnings momentum even during economic slowdowns. Such companies
will provide long-term growth of capital, preserving the investor's
purchasing power against erosion from rising prices, he predicted.
Now that we have the words of the masters let's delve into the Value school today and next time we'll dig deeper into growth.
Buying a Dollar for 50 cents
Value investing is a very simple concept. As Warren Buffett, the legendary
investor and disciple of Benjamin Graham put it, its all about "...buying
a Dollar for 50 cents...". So if you find a cement company which is
trading at Rs120 a share, (like say ACC is) and you believe that the
intrinsic value of the company is actually Rs200 per share because that is
what your analysis of its business, assets and prospects justify, then you
would jump to buy it because it would clearly be a bargain buy.
Value investing is a lot like buying an Arrow shirt at their Annual sale. Or Buying a TV during the festival season when every manufacturer is trying to woo you with a 'value for money' offer - 20 DVD's worth Rs9000 free with a 14' TV priced at Rs14,000. As you can see, in both instances there is an element of waiting for the best bargain and buying at that opportune time. Just like the shopper who scours the market for the best bargain before making his purchase, the Value Investor hunts for stocks that are ' trading at prices that are unduly low in relation to their value and potential.' Price Earnings ratios, Price /Book ratio, Enterprise Value/Replacement value, Dividend yield, Liquidation value. These are the metrics by which Value investors typically place great store. Low P/E & P/B ratios, a discount to replacement value, a high dividend value and a discount to liquidation value can get a value-oriented Investor highly excited.
What does the value investor hope for?
That sooner or later the asset will trade at a price more reflective of
its Intrinsic value and then he, who bought it at a bargain will be
sitting on neat little pile of money (profit).
One of the most popular delusions about value investing is that it is all about liquidation value and does not look at an enterprise on a going basis. Some harsh critics would have us believe that Value investing is the equivalent of investing by looking in the rear view mirror. However, the words of the masters indicates otherwise. Let us go back to the words of Sir Templeton and focus on his choice of 2 phrases - '...longer term, intrinsic value...' and '...prices that are unduly low in relation to their value and potential...'. It should be quite obvious that 'Longer term Intrinsic value' is not and cannot be a function of the past. And mark the use of the word Potential in the second phrase - that again implies a peep into the future. Here's Ben Graham, the author of Security Analysis & Intelligent Investor, and the father of Value investing on the same subject. While it is true that it is the expected future earnings and not the past that determines value, it is also true that there tends to be a rough relationship or continuing connection between past earnings and future earnings. In the typical case, therefore, it is worthwhile for the analyst to pay a great deal of attention to the past earnings, as the beginning of his work, and to go on from those past earnings to such adjustments for the future as are indicated by his further study. What we are driving at is that 'Value' investing does not ignore the future. It merely attributes a lower probability of being able to successfully predict the future.
The attributes of a Value Investor
Value investing places a great premium on a virtue called Patience. If you
are the kind of shopper who rushes into a shop to buy what you came for
and rush promptly out, then value investing is not for you.
On the other hand, if you are the type to walk into 10 shops, compare prices and work out the arithmetic of the special offers before making up your mind, then value investing might be just what the doctor orderd. The value investor does not mind waiting for a bargain to come along - the annual Arrow sale, the festival season... But that is not the only reason why Patience is a key virtue for a wannabe Value investor. It's one thing to possess the tools and the knowledge to figure out that something is trading below its intrinsic value. But you make money from an undervalued stock only when the price finds it correct levels. That happens when more people recognize the fact that the stock is undervalued. And that can be a long, long wait. The fact that value investing places a premium on patience in a round about way again reinforces our belief that Value investing is not a backward looking tool. Think about the cement company in question. As per your estimate its intrinsic value is Rs200 per share today. But remember, its not what it is worth today, but what it will be worth on the day that the market correctly prices it, that will determine the profits you make. What if a new revolutionary technology reduces the cost of building a cement plant by 20% due to a change in the manufacturing process? What if Dupont or BP develops a new plastic that does away with the need for cement next year? Then what? It would be only fair then to presume that in those circumstances ACC's intrinsic value would follow suit and head lower. The Intrinsic value as estimated today is based on our knowledge of the factors that impact the company and our ability to forecast them. The moral of story is that you can ignore the future only at your own peril. And a Value investor must recognize that. The great Value investors knew that. What the Value investors are looking for is Margin of safety. They are looking at buying a stock at as much of a discount to Intrinsic value as possible. This provides them with a margin of safety because the future is always difficult to predict! Growth investors on the other hand have their eyes firmly focused on the future. Next time we'll dig into their side of the story.
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Article 2:
Growth Investing
We've already got a grip on what Value Investing is all about. If you read
our piece on Value, you'll remember that its mostly about patience.
On the other hand, the Growth School bets the farm on the Future. Growth investing, as defined by Mr Thomas Rowe Price, a pioneer of this approach in the late 1930s, is: Growth stock investing focuses on well-managed companies whose earnings and dividends are expected to grow faster than both inflation and the overall economy. The real test for a growth company is its ability to sustain earnings momentum even during economic slowdowns. Such companies will provide long-term growth of capital, preserving the investor's purchasing power against erosion from rising prices. Ok, that's simple enough. This is of course the 'In' school for the past few years. Growth investing has been trouncing value-based investing for the past few years by a wide margin. While we have little data for the Indian market, there is a wealth of it on such issues about the US market. And if you look at the chart below it is amply clear that Growth has been the way to go for the past few years.
The basic assumption underlying growth stock investing is that these companies have above average rate of earnings growth and that over time their stock prices will reflect this growth. The difference between growth and value investing is best understood by the following question.
Would you rather buy a great company at a good price or a good company at
a great price?
Growth investing places great store in buying great companies at a good
price. Not necessarily at a great price.
The metrics of growth investing are very different from that of value investing. They do not place great emphasis on tools such as P/E, P/B, dividend yield or Replacement value. Growth investors tend to look more at the future. So they are more concerned with prospective P/E's and PEG ratios. In other words they are more concerned with the company's P/E based on 2004 earnings than with 2000 earnings. Since they place great store by Intangibles such as brand value, technology edge et al, they typically disregard measures such as Replacement value and Book value. Measures such as Replacement value and Book value are based on accounting entries in the Balance sheet and do not therefore capture the intangible assets of the company. The intangibles could be the company's brands, its human capital or its IPRs. Also, since they are typically on the lookout for high growth businesses, they disregard dividend yields. Not without reason - fast growing companies justifiably prefer to reinvest their profits in their business rather than pay them out. Irrespective of whether you are growth or value investor, Management is always a key attribute in buying a stock. But with a growth company, where the job is not just to maintain consistent but higher than average growth rates, the nature of the challenge faced by management is of a higher order. Without any prejudice to the Value school, it is fair to presume that the premium placed on management quality by Growth investing is definitely in another league altogether. The same applies to interest rates as well. Typically Growth stocks are more sensitive to interest. This has more to do with the growth premium than with debt levels.
Growth premium?
Given their steady but above average growth rates, growth companies
obviously get more attractive during the period when interest rates are
low or are headed lower. However when interest rates head higher, then the
value of the future cash flows gets impacted quite substantially and the
appeal of growth companies does suffer as a consequence.
Also, remember that Growth stocks get a lot of their value from future cash flows. Typically, the impact of future cash flows in a stock's current valuation is much higher than that for a value stock. But when interest rates rise, the value of those future cash flows drops very rapidly, hence making the stock more vulnerable to interest rates. The key issues that a growth company faces are
The question of how to value growth stocks is one that has no
straightforward or simple answers. Unlike Value investing which is quite
well defined and has easy to understand metrics, growth investing is more
difficult to quantify. Discounted Cash Flow (DCF or NPV) is the only tool
that an Investor trying to evaluate growth companies can turn to.
The DCF model has its roots in what is called the Dividend Discount model.
It owes its origin to John Burr Williams who introduced this model in his
Theory of Investment value in 1938. In his words,
"In short a stock is worth only what you can get out of it. Even so spoke the old farmer to his son: A cow for her milk A Hen for her eggs A stock, by heck For her dividends" This is obviously no easy task, because it involves complex calculations and many assumptions. But this remains the only way to value growth stock. It is because it involves so many assumptions about the future that growth investing stands apart from value investing. And because Growth investing is less about a rule-bound approach, it is quite easy to err. Growth stock investors would do well to remember this warning from Warren Buffett in his 1989 Chairman's speech "In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends. A high growth rate eventually forges its own anchor. Carl Sagan has entertainingly described this phenomenon, musing about the destiny of bacteria that reproduce by dividing into two every 15 minutes. Says Sagan: "That means four doublings an hour, and 96 doublings a day. Although a bacterium weighs only about a trillionth of a gram, its descendants, after a day of wild asexual abandon, will collectively weigh as much as a mountain...in two days, more than the sun - and before very long, everything in the universe will be made of bacteria." Not to worry, says Sagan. Some obstacle always impedes this kind of exponential growth. "The bugs run out of food, or they poison each other, or they are shy about reproducing in public."
So which is the better way to make money? Growth or Value investing?
As history shows there have been many investors from both schools who have
met with great success. The key to their success has been their discipline
and commitment to following what they understood best.
Investors who play musical chairs between these 2 styles run a greater risk. The risk of following the wrong strategy at the wrong point!
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Article 3:
Margin of Safety
'What the Value investors are looking
for is Margin of Safety. They are looking at buying a stock at as much of
a discount to Intrinsic value as possible. This provides them with a
Margin of Safety because the future is always difficult to predict!'
That is what we said in our piece on Value Investing. If
you have not read it, we suggest that you may want to do so before reading
this story.
It is clear enough from the above statement that when you buy something at a discount to its Intrinsic value then you enjoy a degree of safety in relation to that investment. The Value Investor aims to buy a genuine Rs500 note (not the fake variety) for Rs200. He is equally willing to buy it for Rs300 or Rs400. But as the price climbs and gets up to Rs499.99 he turns cautious. The reason for his behavior is quite simple. As the price climbs closer to Rs500 the Margin of Safety is eroded.
But that should be obvious enough to all of you.
As for the issue of calculation of Intrinsic value there are several
methods that you could adopt - Liquidation value, Replacement value Book
value or even Dividend Discount Model (Discounted cash flow). The choice
of method depends on what you believe is most relevant to the stock you
want to evaluate.
But what of the intangibles?
However as we move away from the mechanical and quantifiable to the
metaphysical and the world of ideas, it is far more difficult to establish
Intrinsic value. For a company like ACC we could choose very easily to go
with Replacement value as the best estimate of Intrinsic value. That is
not very difficult to calculate. But how do you estimate Intrinsic value
of companies such as Infosys and HLL? Obviously the traditional Balance
Sheet based measures do not help you arrive at a benchmark.
These companies take their value from many an intangible asset, which makes the simple Replacement value or Book value based estimates meaningless. There is no option but to value them as a 'Going Concern' - based on their future profits (Earning streams). In other words you have to turn to models based on Discounted cash flow. But that is no easy task.
Several imponderables underpin a forecast
It involves projecting the company's profits for many years into the
future. It requires making an assumption about that rate at which the
company will grow. And underlying that single assumption are several
assumptions about how the market for the company's products will evolve,
whether their management will continue to be as focused as you currently
believe them to be, how competitors will behave or respond, what
regulators might or might not do in reshaping the competitive environment
and technological obsolescence.
In reality there are hundreds of imponderables underlying that one simple growth estimate. The Margin of Safety is meant protect you against those imponderables. But the Margin of Safety is also meant to protect you against one other error. In the words on Benjamin Graham: While it is true that it is
the expected future earnings and not the past that determines value, it is
also true that there tends to be a rough relationship or continuing
connection between past earnings and future earnings. In the typical case,
therefore, it is worthwhile for the analyst to pay a great deal of attention
to the past earnings, as the beginning of his work, and to go on from those
past earnings to such adjustments for the future as are indicated by his
further study.
In other words the basic Principle underlying the Margin of Safety is
one of 'Continuity'.
In the words of Graham:
We are not suggesting that you drive with your eyes fixed on the rear view
mirror. What we are however saying is that what you see in your rear view
mirror holds the key to what you will see (in front of you) through the
front windshield of the car.
Going rosy-eyed
When you project the earnings that the company is likely to earn over the
next 10 years in an attempt to arrive at an Intrinsic value, you would do
well to remember that. Many an investment mistake can be attributed to
projecting a rosy-eyed view of the future for a company whose past never
justified such a forecast.
But first a word of caution about looking at the past. The past is not just the year gone by. The past is a normalized and reasonably long period of time over which a trend can be discerned. Say 5 years. In other words look at what Tisco's profit growth over a 5-year period has been when estimating its future growth rather than just the last 2 quarters - in which its profits have grown by over 100%.
Why Margin of Safety?
There are 2 types of mistakes an Investor can make - buying a bad stock
and buying a good stock at the wrong price. Nothing other than
rigorous analysis and discipline can prevent the first mistake. But there
is a method to prevent the second mistake. The Margin of Safety.
According to Graham there are 2 methods of analysis and investing, which emphasize value. The first division represents
buying into the market as a whole at low levels; and that, of course, is a
copybook procedure. Everybody knows that is theoretically the right thing to
do. It requires no explanation or defense; though there must be some catch
to it, because so few people seem to do it continuously and successfully.
The second method emphasizes the concept of Margin of Safety and underpins
Value Investing:
Next time you buy a stock, don't stop at asking yourself if you are buying
a good stock. Also ask the question - Am I buying a good stock at the
wrong price?
If you enjoy a Margin of Safety on your purchase then it is likely that you are buying at the right price.
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Chapter 7:
Futures and Options
(What are futures and options? What purpose do
these serve? Find out more... )
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Article 1:
Enter the Futures Exchange
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Article 2:
Forwards- the prelude to Futures
Meet Mohan. He is a farmer by profession. He grows rice in a small village
in Haryana. He sows seeds in the month of February and harvests his crop
in April every year. Whenever there is scarcity of rice in the state, he
sells his stuff at a high price. But when the market is glutted with rice,
he takes a hit and has to dispose of his crop at a throwaway price. Risky
business that, eh?
Sohan runs a rice mill in a neighbouring village. He purchases the rice crop from farmers like Mohan, removes the husk from the crop and sells the rice in the market. There are years, when due to an oversupply situation he is able to procure rice at a favourable price. On the other hand, in times of scarcity, he has to purchase rice at an exorbitant price. So, his business is equally fraught with risk. One February few years back, Mohan expected the price of rice to drop to Rs10 per kilo by April that year due to oversupply in the market. However, Sohan expected rice prices to rise to Rs15. Mohan made up his mind to sell his crop at any price higher than Rs10. On the other hand, Sohan was prepared to purchase rice at any price below Rs15. They bump into each other at a cattle fare in Mohan's village. Soon they get talking and exchange views on their respective businesses. They learn about each other's view on the rice price too. To escape the risk associated with the price of rice, they enter into a deal as per which Mohan agrees to sell rice to Sohan at a pre-determined price of Rs12.50 per kilo. In other words, they entered into a forward contract. Though they sign the deal in February, the actual transaction is carried out in the month of April only.
But what is forward contract?
Well, it is an agreement to buy and sell an asset at a certain time in the
future at a predetermined price.
Now, consider this. If the price of rice had remained below Rs12.50 per kilo that April, Mohan would have made a profit and Sohan, a loss. But if the rice price had crossed Rs12.50, Sohan would have made a neat profit and Mohan would have taken a hit. But thanks to the future contract, nobody would have suffered a loss even if the price had gone against their expectations.
It's a win-win situation for both
How? After entering into the forward contract, Mohan could budget his
general spending on the basis of the money that he would receive by
selling rice to Sohan in April. At the same time, Sohan, knowing his raw
material (rice) cost in advance, could also work out the selling price of
the clean rice. Hence, forward contract helped both the participants do
away with all risks associated with the price of rice.
A forward contract not only helps one reduce the price risk associated with commodities but also eliminates the interest rate risk and foreign exchange risk. Assume that your company is planning to expand its operations. It expects to do so in the next two months and will need about Rs200cr to do so. However, the finance manager of your company is not sure as to what the interest rate will be like in the next two months. It may go up, in which case his company will have to borrow at a rate higher than the existing rate. It may even drop; in which case his company will benefit for it will be able to borrow at a lower cost.
So, what does the finance manager do?
Smart that he is, he approaches his company's bank and enters into a
two-month forward contract for Rs200cr at a certain fixed rate. This
forward contract is called Forward Rate Agreement (FRA). So, how does the
finance manager benefit? Knowing in advance the interest rate at which his
company will borrow, helps him work out the finance cost of the expansion
project. And hence, the viability of the project.
And how does a Forward Contract help eliminate forex risk?
As you all know rupee depreciation hits importers while appreciation of
the rupee affects exporters. However, at a given point of time exporters
and importers can remove this uncertainty regarding the rupee's movement
by signing forward contracts. How?
Let us understand this better with an example. A textile manufacturer wants to import some textile equipment from the US. It will cost him a total of $1000, which he will have to shell out after two months. The current Rupee-Dollar exchange rate is Rs40 per dollar. But after two months, when the textile manufacturer will be required to make the payment, the Rupee-Dollar exchange rate is likely to be Rs45 per dollar! As is evident, the textile manufacturer's import cost will rise after two months in keeping with the depreciation in the rupee's value. So, how does he avoid this extra cost? He approaches his bank and enters into a forward contract to buy $1000 after two months at a pre-defined price that is little higher than the existing rate. This helps him know in advance his finance cost and hence eliminates the foreign exchange risk. But there is one problem regarding a forward contract. Assume that Mohan and Sohan live in two different corners of the country - Mohan in some village in Rajasthan and Sohan, in Tamil Nadu! How would the two meet and transact in such a case? How do they enter into a forward contract? But don't worry. Ever this problem can be solved. How? Wait and watch this place for the solution.
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Article 3:
Countering Counterparty risk
Some time back, we learnt that the futures are traded on a futures
exchange, which works as a guarantor to all trades in futures and
therefore take care of all counter party risk. But isn't it a big risk for
exchanges? How does the exchange take care of this counter party risk?
Default risk can crash the entire system
Futures normally have a maturity period varying from one month to one
year. If the futures exchanges settle these trades on the last day of
maturity, then again the default risk becomes high. And suppose Mr XYZ has
40 futures contracts long and there are 40 investors with short positions
in one contract each. Then if Mr XYZ defaults, 40 contracts will default
and this may crash the systems completely.
Let's answer this question: which is more risky, a full payment of Rs90,000 after 90 days and or a payment of Rs1,000 every day for next 90 days? Of course, the full payment after 90 days. The futures exchanges understand this and therefore instead of a settlement on the final day of maturity, they have opted for daily settlement of all the open positions in the futures. Smart fellows! But if even in this arrangement of daily settlement, Mr XYZ does not pay his one day loss, what happens to the other investors? How does the futures exchange take care of this one day default risk?
An initial margin takes care of compulsive defaulters
Future exchanges circumvent the really persistent defaulters using some
very prudent measures, thus neutralising counter party risk. They require
that both the parties involved in the future transaction pay an initial
margin to the exchange. The margin is fixed based on the maximum
historical price movement on the underlined asset. The BSE has set an
initial margin of 10% on Sensex futures, while the NSE requires a 7%
initial margin on Nifty futures. This initial margin is expected to cover
at least one day's price movement in the Sensex or Nifty. (We will learn
about the Sensex and Nifty futures in the following series).
Futures are settled on a daily basis, depending on the market value of the future's closing price. But how does the daily settlement take place? Is it a very cumbersome process? In a word, no.
Futures are cash settled
The most beautiful thing about futures is that they are cash settled.
There is no delivery of asset required of a party who shorts the future
and vice versa. So if your position in a future makes a profit, then you
receive cash.
The daily settlement also takes place through cash. So if you are holding a long position in future and today it ended above yesterday's level, then you receive the difference between yesterday's price and today's closing price. This transfer of funds is also known as daily margin, which is based on mark-to-market basis. So does one have to take care of daily cash transactions?
Margin account makes it easy
In reality, when you enter into a futures contract, you deposit a certain
amount in your margin account with your broker. Normally, this opening
balance is above the requisite initial margin set by the exchanges. This
extra amount is to take care of losses on your position in futures, if
any. But what happens if the amount in the margin account becomes zero?
The margin account can never reach zero level because your broker will not allow you to carry the position in the futures if the account balance falls below 10%. If your position in the futures keeps making losses and the account balance falls to 10%, then your broker will ask you to refill the margin account to 15% of the current exposure in the futures. So the losses in the futures have to be paid as soon your account falls by 5%. But what about the profit on your position in the futures? Are they being paid to you according to your margin account balance? Yes, the profit on the futures positions are also settled based on the balance in the margin account. So if your margin account balance goes above 15% of the current exposure, then you can withdraw this extra money from your margin account. But in practice, this is done once a week on a weekend. If your margin account balance is in excess of 15% of the current exposure on futures on Friday, then you can withdraw that amount on that day. Let's take a simple example of a future contract, which you bought at Rs1,000 on 3rd January 2000. The future behaved in the following manner for the next 10 days.
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Article 4:
Introducing index futures
We saw earlier in the features on the forwards and futures that these
instruments allow you to remove the price risk in the market from your
investments. This price risk may arise from commodity prices, interest
rates (bonds), foreign exchange and also stock prices. All the previous
write-ups on futures were applicable to all kind of futures, but from here
on we will concentrate on index futures only, our focus being the equity
markets.
What are Index futures?
Index futures are contracts to buy and sell a stock market index at a
fixed time in the future at a price agreed upon today. So if the
underlying index is the Sensex, then the futures are known as Sensex
futures and if the underlying index is Nifty, then they are known as Nifty
futures.
Index futures are standardised contracts defined by the future exchanges and are trading on these futures exchanges. The standardisation is in terms of the time of expiration and the value of these futures contracts.
Expiration and value of futures contracts
Both Sensex and Nifty futures have a maximum life of 3 months and, at any
point in time, there are 3 series of the index futures trading on the
exchanges. The price of the contracts is fixed by defining a contract
multiplier, which is 50 for Sensex futures and 200 for Nifty futures. So
if you are buying one Sensex future contract at Rs4,000, then the contract
size will be Rs4,000 x 50 (contract multiplier of Sensex futures) =
Rs2.0lac. Similarly, if you are buying Nifty futures at Rs1,250, then the
contract size for the Nifty future will be Rs1,250 x 200 = Rs2.5lac.
If index futures have a fixed expiration date, what happens to contracts that are not settled during the life of the index future? All such contracts, which are not settled during the life of the index futures, are settled at the final settlement price. This final settlement price is derived from the average of the last half an hour trading values of the cash market (Sensex/Nifty).
No delivery, 100% cash settled
The Sensex is composed of 30 stocks, the weightage of each based on the
market capitalisation of the stocks. If you sold one future contract, then
at the time of expiry you will need to deliver the Sensex, that is, its 30
stocks based on their weight in the index. This delivery of 30 stocks
according to their weights in the Sensex could be a cumbersome process,
and to avoid all such bother, index futures are settled in cash - profits
and losses. If your position in the index future turns in a profit, then
you will receive the profit equivalent in cash and if it makes a loss,
then you pay the loss in cash.
Fixed maturity date makes it a zero sum game
An index future contract is struck between a buyer and a seller at a fixed
price. The future contract has a fixed maturity date on which all the
outstanding contracts get settled at the closing price. So, if the closing
price of the index future is above the fixed price, then the buyer of the
contract makes money and the seller of the contract loses money. And since
the contract is between the two parties, the profit of one is the other's
loss, meaning, there is no value created in the system. Hence the index
futures are also known as zero sum game instruments.
Highly leveraged
In the feature on counter party risk, we saw that an investor can take a
position in the index futures market by paying an initial margin of just
15% of gross exposure. Also, until your margin account balance is above
10% of gross exposure, you don't have to pay any extra money. This 10-15%
margin requirement allows you to leverage your money from 6-10 times -
that is, you can take an exposure up to 6-10 times of your investment in
the market.
What is the premium for this facility?
There are no free lunches in this financial world; you do need to pay some
premium for this leverage facility. But how much premium and how is this
calculated? We shall walk down that road in the next of this series -
`Pricing of Index Futures'. So keep in close touch with the Sharekhan
School to better understand the unique world of index futures and more.
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Article 5:
Pricing of index futures
As we learned in our introduction to index futures, these are contracts to
buy and sell a stock market index at a fixed time in the future at a price
agreed upon today. Index futures are known as derivative instruments
because they derive their value from the underlying index.
Taking exposure in Indian equity markets
There are two different ways to take an exposure in the Indian equity
markets. In the first, you can pay the full amount of the exposure and
take delivery of stocks. If you choose to do this, you need to invest 100%
of your investment. Or, you could use the carry forward system, where you
pay an initial margin (maybe 15*-20% of your desired exposure) while
adopting a position and then carry forward this position in the market by
paying the badla charge every week.
Suppose you want to take a position in the market for 2 months; then, with the first system of 100% investment you have an opportunity cost on your investment. While in the second case of the carry forward system, you need to pay the badla charge, which is, normally, the interest rate ruling in the market. In both cases, you need to pay some financial cost to take a position in the market.
The third route - index futures
Now with index futures, one has a third way in which to enter the equity
market. If you want to take a position for 2 months, you buy index futures
with a maturity period of 2 months. Here, you can take a position by
paying an initial margin of just 10-15% and no extra cost thereon.
You're now wondering if there's some scope for arbitrage between first two options and the third? Sorry, there are no free lunches in the financial markets. The third option actually includes the financial cost in advance. So, if you are buying an index future contract with 2 months to expiration, then you will be paying some premium to the ongoing index value at that time. This premium over the index value is known as the 'cost of carry'. Fair Value of the Sensex Future = Prevailing Sensex Value x Cost of Carry
Calculating the cost of carry
As we saw above, the only difference between the cash market and the index
futures market is the financing cost and therefore the cost of carry
should be equal to the financing cost.
Cost of Carry = Exp^ (Interest Rate x Time to Maturity) More about Exp But what about the dividend earned on delivery positions? There is no delivery system in index futures; they are settled in cash. If there is any dividend on any of the Sensex stocks during the maturity of the index futures, then this should be adjusted in the index futures value. Suppose you buy an index future contract with 2 months of maturity and during that period the Sensex stocks were expected to give out dividend. You then need to find out the dividend yield based on per contract exposure. The cost of carry becomes: Cost of Carry = Exp {(Interest Rate - Dividend Yield) x Time to Maturity}
Do index futures trade exactly at their fair value?
The answer is no. The traded value of an index future varies from its fair
value, based on the demand and supply of that future contract. But who
determines the demand and supply of these index futures? Who are the main
participants in this index futures market? Find the answers to these
questions in our next in this series on index futures!
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Article 6:
ignore
Why we need a philosophy to investing
When you come to a road crossing, how do you decide which way to take? Do
you follow the road signs, look at the map, ask someone for directions, or
just go right ahead and take a random shot?
If you choose to follow the first option, then you do have a certain philosophy at work. As the Cheshire cat put it so eloquently in Alice in Wonderland: if you don't know where you're going, it doesn't much matter which road you take to get there. Obviously this means that you need to, first and foremost, develop an idea of where you wish to go with your portfolio. No, just "we want to make money" is not enough - a good start maybe, but not enough to qualify as a philosophy!
What is an investment philosophy?
"An investment philosophy is a set of guidelines by which investment
decisions get made. These guidelines help to achieve the well-defined
goals of the investor. These guidelines are usually informed by academic
findings, actual experience and/or desired investment goals. The important
point here is that the investment philosophy represents a set of
guidelines and not fixed rules."
My Rule No. 1: Think Portfolio
When we invest in the equity market, we never think of investing in one
single stock. We always look at buying more than one. Many of us buy more
than 30. In the course of our practice, we have come across people who own
500 stocks in their portfolio!
My Rule No. 2: The objective is diversification of risk
You might want to ask us at this point if a portfolio consisting of only
10 (for the sake of argument) steel companies constitutes a good
portfolio? No. The portfolio approach calls for diversification. And you
do not achieve that when you own a portfolio of just 10 steel companies.
The factors that affect the steel business will take their toll on each of
the steel companies. Even the market risk does not get spread out. Hence,
this portfolio is as risky as one with just one steel company. It fails
because there is no diversification across various businesses. An
important point to note is that while we advocate diversification -
diversification is the means to an end (returns), not an end in itself.
My Rule No. 3: Don't spread your net (portfolio) too wide
We believe that by casting our net wide across many stocks, at least a few
of them will turn out winners. We spread it to decrease risks. However,
most investors forget that there is a trade-off between risk and return.
As the number of stocks keeps increasing, not only does the portfolio
become unmanageable, it begins to reduce your total return. Using a
medical parallel, think of it as too many pills resulting in an
undesirable side effect!
As a rule, WE advocate that the number of stocks in a portfolio never be more than 15 or, at the maximum, 20. Beyond this, it becomes difficult to track so many companies (and they start creating holes in the portfolio). Also, do the arithmetic: if a stock accounts for just 1% of your portfolio and it doubles, your portfolio return goes up by just 1%. Hardly anything to get excited about.
My Rule No. 4: Determine your risk profile before creating your portfolio
You cannot have low risk and high returns. We hate to disappoint you, but
that is the truth. There are no magic wands. You cannot "have your cake
and eat it too." A portfolio is always a trade-off between risk and
return. Having a portfolio is all about balancing between these two
opposite forces. Hence, it is important that you understand your risk
profile before creating a portfolio.
Portfolio creation is all about optimising returns, given a risk profile and an investment horizon.
Some final tips
Well, that's about it for the rules and philosophy of investment. But
before we finish, We would like round off this session with some more
words of advice...
Recognise your risk profile: Your risk profile is a function of your age, ability to withstand losses, investment horizon (time), existing cash flows (income), past experience and expectations from the market. Risk profiles are unique to every individual and they can only be classified into broad categories to simplify issues. Think "clusters" the way we at Sharekhan do: We have created clusters that stand for certain risk-return profiles. Our Evergreen cluster, for instance, has the lowest risk. The risk increases starting with our Apple Green cluster to our Emerging Star cluster. Ugly Duckling and Cannonball are "quick churn" clusters, again standing for different degrees of risk.
Conclusion
Seek to build a diversified portfolio, which will double its value every
three years. There are going to be bear and bull cycles. It's always going
to be difficult, if not impossible, to keep up with those cycles in a bid
to make the most of the volatile markets. An investor needs to live out
these cycles and survive, for there is no guarantee how long a bear market
can last. The idea is for you to last... much longer than it! And only a
disciplined philosophical approach to investment will show you way to that
goal.
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Chapter 8:
Portfolio Strategies
Learn to distribute your eggs in different
baskets wisely.
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Article 1:
Choosing your rainbow
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Portfolio diversification Both husband and wife shouldn't work in dotcoms, after all you need to diversify your risks.
Why I avoid working with my better half in the same company
... and this has nothing to do with the fact that I could not then flirt
with all the beautiful girls in my officeJ.
Nor does it have anything to do with being my own master - eating at will,
having as much coffee as I please, going to all those late office parties,
etc.
I work with a company operating in the dotcom space and my wife works as a jewellery designer. So what am I doing here, recounting to you my family CV? Well-l-l-l... because, you see, it all comes down to reducing the element of risk in our lives and the streams of income that support it - and sharing office space with our spouse would hardly contribute to that cause, would it? Remember the 'oft repeated advice our elders and betters always gave us - "don't put all your eggs in one basket?"
Same principle applies to stocks
Obviously we complicate our lives so in order to spread our risks - life
is unpredictable enough as it is! And the same principle applies in other
spheres of life, eggs, jobs, or investments. Wisdom says that you should
not risk everything you have on the success of one plan. More pertinently,
you shouldn't put all your money into one business.
Extending the principle to investment, it follows that it must also not be advisable to put all your money into one stock. No, not even if it's a winner like Infosys. In other words, the one who has a diversified portfolio stands a better chance of surviving carnage in the market than the one who puts all his bread in one or a few stocks. And that brings us to our topic of discussion - portfolio diversification.
FAQ
How can you tell if there's enough diversification in a portfolio? Are
there a certain number of stocks to shoot for? Or certain industries that
should be represented? What's the best approach to take?
Most portfolios begin with the purchase of a single stock. It isn't until sometime later that thought goes into the building of a diverse portfolio. Perhaps the first thing to consider in building a portfolio is that it is not necessary to own a stock in every industry. There are over 125 different industry classifications that one can have in the Indian context and I'm pretty sure that any personal portfolio should not have that many stocks! There are a great many investors who follow the industry approach to investing, the idea being to find a promising industry with well-defined growth potential and then to buy a stock in that industry that appears to be reasonably priced and with the best record. There's nothing wrong with that approach as long as the investor doesn't become, what should we say, a trend chaser.
But isn't the software sector too good to miss?
Too many times, we hear that an industry, say biotechnology or software,
has a bright future. That makes some investors think that they have to
have a biotechnology or software stock in their portfolio. They end up
buying one, regardless of what its financials are like. The future is not
guaranteed for any company just because it operates in a particular
industry that has a strong growth potential. It still comes down to the
quality of management and how effectively the management team can direct
the future of the company.
Overdependence on one sector, however hot, is not a good idea
The reason for diversification is to spread the risk. Overdependence on
any one industry can hurt a portfolio's performance if there is some bad
news about that industry. It has been my experience that all the stocks in
a particular industry may decline when there is some bad news about the
future of just one of the companies that can be traced to an industry
problem.
Take for instance Infosys, Satyam and Aftek, all three of which were commonly held in the same portfolio because of their superior growth records. But this turned out to be a big mistake when all infotech stocks plummeted over the past 6 months. Just think, I even knew some guys whose portfolios had as much as 90% of assets in software alone! I
The magic number: 20 and no more
That brings us to the percentage of the portfolio that should be in any
one stock or industry. There may not be an exact answer, but in a large
portfolio, a prudent approach might be to have no more than 20% of the
portfolio's total value in one single stock. As a portfolio is being
built, that percentage might go as high as 25%. At the same time, I don't
think there should be a formula to sell stocks just because they have
performed well and exceed the said guidelines. For a sectoral breakdown,
one would ideally not allocate over 35% to one single sector or segment of
the industry. This would ensure that the fads of the market don't
undermine the long-term portfolio.
For example, an investor can have 15% of his portfolio in a particular stock and because it performs well, may find that the percentage grows to 25%. Some investors feel a portion should be sold so that there won't be overdependence on that one stock. While this could work for some, for others, the approach is to add to the other holdings to bring the percentages more in line with the target percentage holding. Otherwise, you may find that you are selling the winners and are left with those stocks that may not perform as well. This is something that the Hammock will need to tackle soon
Invest as much as you understand...
I am not sure if there is an exact answer to how many stocks a portfolio
should hold. An aggressive investor may be comfortable with only a few,
while others may want to spread the risk over 20 or 25 different stocks.
My feel is that the number of stocks in your portfolio is directly linked
to how many stocks you can manage to handle and understand. After all, you
are buying into businesses and you need to understand them, at least
somewhat. I recommend that somewhere around 15 well-chosen stocks should
bring you most of the benefit there is to gain through diversification.
In a nutshell
"Don't put all your eggs in one basket." Good advice like no other. When
it comes to investing, diversification - putting your money into a variety
of stocks that have different return potentials and risk levels - means
not putting all your eggs into one investment basket. Since market cycles
vary, diversification will allow you to offset possible losses in one
investment with potential gains in another and, as a result, help reduce
your overall exposure to risk.
So, from now on, every morning when you wake up and look in the mirror, ask yourself this: Have I diversified my portfolio today?
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Article 3:
Diversifying risk
You must have encountered this term many times. In fact, we talked about
asset allocation as a means to come to terms with volatility.
We all understand that where we put our money has an impact on the profits we make. Imagine being invested 100% in software stocks in 1999 and 100% in bonds in 2000 J, all of us would probably have given an arm and leg to have got that 'asset allocation'. Spare a moment here to think if one was 100% invested in bonds in 1999 and 100% in software stocks in 2000 J All of us never keep all our investments in one class of assets like gold, real estate, bonds, stocks or cash. It is always distributed across these asset classes. We do it to spread risk obviously. This is what asset allocation is all about.
The need to diversify
Take a look at our earlier example. On hindsight, may be it made sense to
have 50% in software stocks and 50% in bonds during 1999 and 2000. That
way one would have compensated for another. Essentially, one would have
diversified risk and may be settled for a potentially lesser profit. But
then it means two years of more peaceful sleep.
Hence, investors not only diversify across various stocks
While asset allocation is a simple concept to understand, the tricky
part is to figure out how much money to put where.
The "Rule of 110"
Similarly, there is an empirical rule for asset allocation called the
"Rule of 110".
Subtract your age from 110 and that in percentage should be the proportion of your assets in stocks. In other words, if you happen to be 30 years of age, you should have (110-30) 80% of your assets in stocks. So when you are 60 years of age you will have 50% of your assets in stocks. But what if at 60 years of age you are very healthy, your children are very well off and you have no financial responsibilities? Then may be you could look at having a higher than 50% exposure to stocks. But the caveat is that you would be assuming higher risks.
Keep the thumb rule in mind
Remember, this is just a thumb rule and not a patthar ki lakir
(something which cannot be overruled). Just like everyman who is 180cms
tall does not necessarily weigh 80kgs
J
Whenever you don't follow the thumb rule of asset allocation, be aware about the risk profile you have created. Allocating more than what the thumb rule says to stocks is assuming a higher risk whereas anything below the limit would mean assuming lesser risk and hence settling for lower returns.
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Chapter 9:
Essentials of stock picking
(Learn to spot a winner )
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Article 1:
The world outside the well
The trend on trends
You must have heard analysts on CNBC talk about business trends. What is
that about and how do they help gauge a company's health? Don't financial
ratios determine whether the company is in good financial health, and
measure all parameters of company efficiency, besides tracking their
growth?
We have seen the entire gamut of basic ratios that value businesses - book value, EPS, PE, RoE, RoCE - and their relevance to stockpicking. But while that helps in valuing the financial health of the company, there is still a lot more that goes into buying a good company. There are factors prevailing in the environment that determine profitability and growth. Which is why the study of trends comes in. Let us take a look at business environments in the next few paragraphs. Our objective is to suggest which factors to look for while picking a successful business. How not to believe everything you see. Financial ratios follow good business trends, i.e. they happen after the business cycle.
Being alert to and using external trends
"Despite the management's continuing effort to
improve efficiency and control cost, and achieving higher throughput, the
operating profit before depreciation, interest and tax had gone down by
18%. This was mainly due to the decline in net sales realisation as a
result of very competitive conditions prevailing in the market." -
Directors Report, ACC for FY2000.
What went right? The efficiency of the manufacturing business improved. All internal factors that could result in cost saving were implemented. This ideally should have led to a higher profit margin. Did this happen? No. While the company was cutting its costs, the sale price of the final product came down because of competitive (external) pressures. The business was in a state of oversupply, which was pushing down selling prices and reducing profits.
Controllable vs. not controllable
With ACC, the downfall in profit was due to external factors, something
companies rarely are able to influence, rather than internal factors such
as cost saving, which it dutifully took care of to no avail. In contrast,
Infosys had external factors on its side - spends in tech worldwide were
booming - and it rode the trends well. The management was farsighted and
did not look just at building profitability on near term opportunities
like, say, Tata Infotech did. Tata Infotech is a case of how a company
despite a booming environment can falter by not being alert to trends
forming in the industry.
How business environment affects companies
An environment builds the platform on which a company survives and grows;
it has to be supportive to the business's growth. Not too many companies
can continue to grow when their economic environments are clouding over.
The basic economic factors hold true while looking for a business to
invest in. Does the demand-supply equation favour the company's operation
to be viable and make money? Of course, that is the idealistic scenario,
but the viability of the business centres on the broad parameters of
demand and supply in the industry.
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| Article 2:
Businesses that make good stocks Good businesses make great stocks, there is more to this truth.
The secret to that lies in the answer to this question: what makes
successful businesses? Of course successful business are those that can
earn money. The following factors may shed some light on whether the
business in question is making money?
Business continuity
First, look at continuity of business. Take the instance of Tata Infotech.
While the entire technology sector in India was thriving on the Y2K
solutions business, this company overfocussed on this area and failed to
reinvent its skills to fit into a post-Y2K scenario. The outcome is there
for all to see in the stock price. Although it brought in the bread in the
initial years, the orders dried out towards the end, as they inevitably
would. Continuity in growth was broken.
Take the example of a company in the electronics sector. The Indian government-owned EcTV closed down operations when it failed to take advantage of other business opportunities. It was once the largest seller of television sets in the country. Another example in this industry was Videocon VCR, which was set up as a standalone manufacturer of VCRs. The company failed to be alert to technological advancements, which sounded the death knell for the outdated VCR, and obviously for the company too!
Adequate capacity
Second, look at capacity. How big is beautiful? Size brings in economics
of scale all right - costs are spread over a larger output, bringing down
cost. But bigger isn't necessarily better in this case. Companies can grow
out of control. Arvind Mills built 10% of the global denim capacity,
creating an oversupply situation. When these capacities went on stream,
prices of denim dropped and the infrastructure costs just killed the
company. Arvind couldn't go close to achieving full capacity in its
manufacture, which it needed to do to be viable.
Something similar happened to Core Healthcare. The company scaled up its capacities to 60% of India's IV fluids capacity. The market just could not absorb this capacity and its quality was found wanting in the international market. The obvious happened: losses mounted and the company completely eroded its net worth. Big could also mean small, but dominant in its area. Small companies in niche segments which nevertheless rule their sectors. Like Himatsingka Siede, a designer house that is making it big in the international silk furnishing business, catering to a select market and never going in for overkill. Capacity as much as
the market needs,
Survival ability
Competition kills and this is one major cause of failure. Hindustan Lever
has over the years taken the competition to its rivals and expanded its
portfolio. When growth from its bread and butter business of detergents
and soap was plateauing, the company found new outlets to grow. In the
last two decades, this survival skill transformed HLL into an FMCG
conglomerate with powerful cash flows. The survival factors here are more
to do with the ability of the management to see future trends in their
business.
Subsidies and barriers to entry
In numerous cases, to encourage the development of a business or of
society, governments resort to subsidising services and equipment in order
to make it viable for manufacturers to develop infrastructure. But such
sops-dependent businesses may not make for wise long-term investments.
Once such benefits are withdrawn, as they must eventually be, companies
are exposed to the cold chill of ruthless competition, which may squeeze
margins and reduce cash flows. Monopolies also bring with them
inefficiencies that are hard to scale back in a free regime. An apt
example is MTNL, a public sector telecom unit that in the last few
quarters has been struggling to maintain its profitability and market
share.
Talking about subsidised businesses, Renewable Energy Systems and NEPC Micon are two companies that actually thrived on subsidies to grow their profits. That's all they did. In a crunch, when subsidies were withdrawn, they found themselves uneconomical and unviable because their products weren't as efficient as alternatives available in the market. The markets have recognised these factors at the earlier stages and valued these companies at a meagre 10 times their earnings. Monopolies and subsidised business come with a disclaimer: though cash flows are strong, returns will exist only as long as the happy situation does
Minor points to watch, from the company's viewpoint
Appropriate infrastructure: The infrastructure should complement
the market where it sells its product or where it procures its raw
material. You can't have a cement plant in Karnataka and try to service
the Delhi market. It would be far more expensive just to transport goods
that far, thus spiralling costs.
Watch competition
Increase in capacities usually comes at the crest of the product cycle
Efficient companies go the distance. In an industry revival, these are the first to rebound
Novelties don't make lasting businesses
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Chapter 10:
Psychology of Investing
(Our mind our biggest enemy! Hard to believe?
Discover the mind minesą )
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Article 1:
Meet the 'Mind Traps' Here is a quick test to determine your
Investment Quotient (IQ).
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Article 2:
Linear thinking
Imagine that an investor has two stocks that
trade at the same price of Rs100. However, the investor bought one of the
stocks at Rs50 where as he bought the other one at Rs140.
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the end