MORE ON INVESTING
Chapter 1:
On Stocks
(Demat? Book Building?? Buy Back???
)
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Article 1:
Yeh demat-shemat kya hai
So, what IS dematerialisation?
Dematerialisation is an ugly word. Apart from its polysyllables, it
conjures up scary visions of your share certificates dissolving into thin
air. Nothing, however, could be further from the truth. As a matter of
fact, dematerialisation is one of the best things that could happen to
your share holdings.
Let's get the formal definition out of the way. Dematerialisation is the process by which your holding of physical share certificates is converted into an electronic record. What that means is that just as a bank holds your money in a savings account, the record of your share holdings is held by an institution called a depository.
But why on earth would I want to exchange my physical share certificates
for an electronic record?
For some very obvious reasons. How many times have you worried about the
thousand things that could go wrong while transferring shares in your
name? How many nightmares have you had imagining the theft of your share
certificates? Or, their getting burnt or lost? Second, whenever you have
read in the newspapers about forged and fake certificates, you'll admit
that you've wondered if some of the ones you hold and have yet to get
transferred are fake as well. Haven't you cursed the whole chore of
sending your certificates by post to the company's registered office for
transfer? How many times have they been returned with the terse remark --
"Objection". Dematerialisation, or demat for short, is the magic wand that
drives away all these worries.
How?
Demat shares are an electronic record, so there's no question of their
being fake. Nor need you worry about bad deliveries. There is no physical
share certificate and hence no need to find a safe place to keep it under
lock and key.
I am still not convinced!
There are other good reasons for demat. The introduction of
dematerialisation has also allowed us to dispense with the concept of
marketable lot-even one share can be bought or sold. In the old world of
physical certificates, typically shares could be traded only in lots of
100. Demat is great for small investors, as it enables them to buy even
shares with high rupee prices. It also gets rid of the problems relating
to odd lots that typically trade at a discount. Next, bonus/rights shares
allotted to you can now be immediately credited to your account-no
problems of getting the scrips through the post, the certificates getting
lost, etc. And what's more, you can receive the statement of account of
your transactions/holdings periodically, just like a bank statement.
So, how does one dematerialise shares?
Convinced about the arguments in favour of dematerialisation? The next
step is to know how to go about it. You'll have to approach a depository
participant (DP), who is usually a broker or a banker, to open an account.
You cannot directly approach the depository, whose role is something akin
to that of the RBI-so only depository participants (DPs) have accounts
with them.
What are the various steps involved?
Start by getting a list of DPs-your broker will be only too happy to
oblige. The DP is your link with the depository. Next, submit a request to
the DP in the dematerialisation request form for dematerialisation along
with the certificates of the companies to be dematerialised. Before
submission, you have to deface the certificates by writing "SURRENDERED
FOR DEMATERIALISATION" on them. The DP will issue you an acknowledgement
slip duly signed and stamped. When the issuing company or its registrar
confirms accepting the request for dematerialisation, your account will be
credited automatically. It's as simple as that.
What happens to my share certificates?
Dematerialisation, as you can see, is therefore the process in which your
physical share certificates are first taken back by the company, or its
registrar, and actually destroyed. Then, an equivalent number of
securities are credited in your electronic form to your account. The
process should take around 15 days. One important point-the shares have to
be in your name before they are sent for dematerialisation.
What if I want my share certificates back?
For those conservative souls who want to be able to keep the way back
open, just in case, there's always rematerialisation. If, for some
unaccountable reason, the urge to hold paper overwhelms you, you can go in
for rematerialisation, where the shares will be converted from the
electronic to the paper form. In that case, your DP will forward your
rematerialisation request to the depository, after verifying whether you
have the necessary securities balance. The depository, in turn, will
inform the registrar, who will print the certificates, and despatch them
to you. This should take about a month.
Will I need the services of a broker?
You'll notice that the depository is the securities bank, and the DPs are
its branches. Just like a bank, your DP will give you a passbook, or a
statement of holdings. There is no restriction on the number of DPs you
can open accounts with. However, as in the physical segment, all your
trading will have to be channeled through a broker. And while buying or
selling shares, you must provide your broker with your account number, and
your DP's identification number.
Is dematerialisation expensive?
Not really. Stamp duty has been waived completely to make share-transfers
in the dematerialised segment more cost-effective. In the physical
segment, the stamp duty is 0.50 per cent of the market value of the shares
transferred. As for the custodial fees, they range between 0.05 per cent
and 0.10 per cent, and vary between DPs. Yes, you'll argue that while
physically holding shares, you don't pay custody charges at all. Moreover,
in the demat segment, you have to pay the annual service charges even if
there are no securities in your account. And DPs will charge around Rs 2
to Rs 5 per share certificate for dematerialisation. Some DPs also charge
for opening and closing accounts. But consider the advantages. A
depository relieves you of the bother of sending your shares for transfer,
and saves you the postal and courier charges. Demat's the way shares are
going to be in the future.
Is trading in demat shares time-consuming?
On the contrary, buying and selling in the demat mode can potentially be
much faster. For dematerialised shares, the exchanges have an additional
trading segment known as the rolling settlement (T+5). What this means is
that all trades executed on a particular day (T) will be settled by the
following fifth (T+5) working day. When you buy shares in the demat mode,
you become the owner of those shares in the electronic form within a day
of the completion of the settlement. Similarly, when you sell shares in
the electronic form, you receive the payment much faster.
Any other advantages?
Sure. When you buy/sell shares in demat, all you have to do is that, after
confirmation of the purchase/sale by your broker, you should approach your
DP with a request to debit or credit your account, as the case may be, for
the transaction. Your account will immediately be updated. The biggest
advantage of demat is that it has resulted in a drop in transaction fees
charged by brokers. Why? Because their hassles and the risk of shares
turning out to be objectionable, fake, forged, etc. are vastly reduced.
As you might have noticed, the whole depository and demat business, despite the forbidding jargon, is just like operating a bank account where shares, instead of money, is kept.
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Article 2:
Book building tomorrow’s IPOs
Bookbuilding: in the spotlight
You'll have read about the thumping success of the Hughes Software issue.
You'll also have noticed the pink newspapers going ga ga over the success
of what they call "the country's first issue through the bookbuilding
route". What exactly does bookbuilding mean? How is it related to an
issue? These questions are important because bookbuilding could be the
future of public issues in India.
It is the way in which new issues are marketed in the developed countries. Now that Sebi has allowed the bookbuilding method to be used for issues above Rs100cr, and looking at the large premium that Hughes Software has been able to get, it may well be the future mode of issues here as well.
But what does it mean?
Let's take a look at the issues (no pun intended) involved. The basic
difference between book building and an offer through the normal retail
route is that in bookbuilding the price at which the issue is done is
determined based on the demand received. In the conventional public issue
the price is decided first and then the stock is offered to investors.
"Price is determined based on demand".
Sounds complex? Here's how it's done
Let me explain. A company going public approaches its lead manager, who's
an investment (merchant) banker. Often the lead manager is actually a
consortium, or a group of investment bankers, which helps spread the
risks. The company specifies the amount of shares on offer, and
collaborates with the lead manager in drawing up the offer document. No
price is set in this document. Instead, a price band is shown, merely to
indicate the likely price. The document, which is called the prospectus,
is then filed with the regulator, such as Sebi, which gives it a legal
standing. The lead manager, also known as the underwriter, (because he
gives a commitment to the issuer on the entire or part of the funds the
issuer is trying to raise at a certain floor price) is responsible for
errors in the prospectus. In the US, lawsuits take place if the prospectus
is untruthful, and the damages awarded are large enough to ensure that the
underwriter has a strong incentive to provide the correct information.
The lead manager is promised a fee for marketing the issue, which is typically a percentage of the proceeds of the issue. This ensures his incentive to obtain as high a price as possible for the issue.
Determining the investors' demand function
The lead manager now invites investors he knows into the initial public
offering (IPO) process. These are institutional investors, and
participation is by invitation only. In India, however, Sebi allows retail
investors to be part of the process. The issue manager asks each investor
for the number of shares he would buy and the price at which he would buy.
This is known as the investors' demand function.
But wouldn't the investor quote a lower price? Yes, it is in his interests to quote lower, but he would balance that against the fear that he wouldn't get the number of shares he asked for. After all, the process is like an auction, the difference being that he doesn't know what price the others are offering.
Getting to the market-clearing price
Only the lead manager knows the demand function of all the bidders. Based
on these bids privately revealed to him, the underwriter comes up with a
final price, which is the highest price at which the entire lot on offer
can be sold. This is known as the market-clearing price. Once the price is
established, and the company making the IPO agrees to it, the underwriter
has a good deal of flexibility in deciding exactly how the shares are to
be allocated amongst the various investors. That's another check on the
investors' playing fair in the bookbuilding process. In practice,
relationships between investors and merchant bankers have been built up
over time, and investors know that any hanky panky will result in their
not getting a decent share in the future.
Finally, the shares are allotted, and listed on the stock exchange. It is here that one of the most interesting parts of the bookbuilding process begins. The underwriter or lead manager puts in a limit order to Buy on the exchange at the offer price of the IPO. What this means is that he will be open to buying back any amount of the shares on offer at the price of the IPO. This order stays open for roughly a week. This is called price stabilisation. The idea behind this requirement is to force the lead manager to disclose the right price and set a benchmark price at which there are no sellers.
A superior alternative to traditional IPO process
In India, the current long process of tapping individual investors leads
to delays in the IPO process as well as under-pricing. Currently, it takes
more than a month to get over the entire process of making a primary
issue. Thousands of individual investors take part in the process, and the
paperwork involved is horrendous. These retail investors are unable to
distinguish good issues from bad ones. This results in their fear of
paying too high a price, leading to under-pricing across the board. In
retail IPOs, companies, and merchant bankers, are actually catering to the
least informed investor. Bookbuilding, which arrives at a consensus price
by informed investors, is a better way of accurately judging a company's
potential and the price of its scrip.
But more clarity on rules is needed
In India, an earlier attempt at bookbuilding by Nirma had fizzled out, and
the Hughes Software issue was the first successful attempt. One notable
feature has been that the price discovered through bookbuilding is then
used for an IPO using the retail route. Sebi rules currently say 10% of
the entire issue must be offered to retail investors in this way. This
ensures that retail investors are not shut out of the market. However,
many of the rules are still hazy, and the responsibility of the lead
manager in supporting the market post-issue, does not seem to be well
realised.
But success breeds success. Investment bankers, investors and regulators will all learn by experience, and India, like the rest of the world, will ultimately go the bookbuilding way.
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Article 3:
Stock buy-backs
What is a buyback?
A stock buyback is exactly what it says it is-a company buying back its
own shares. Investors love it. For several reasons.
First, a buyback, to be effective, has to be at more than market value. So investors gain. Second, the announcement of a buyback is enough to send the stock up in the market, so investors gain again. Third, a buyback announcement is a very strong signal from the company management that they believe the market has underpriced its stocks. It is a chest-thumping way of saying that we're better than what the market thinks. Four, stock buyback effectively sets a floor for the scrip. It's like the management saying--Look, this is what we think our price should be, and we'll buy if it goes below that. Five, stock buybacks increase earnings per share, which is nothing but the net profit divided by the number of shares. Since the number of shares comes down in a buyback, the EPS obviously rises. Six, these days many companies offer stock options to their employees, which is nothing but the right to buy stock at a certain price at a certain time. The effect is to dilute equity, that is increase the number of shares, which means a lower EPS. A buyback counters the effect of this dilution.
Restrictions are blamed for the paucity of buybacks in India
Sounds too good to be true? No wonder market bulls kept on telling the
finance ministry that the absence of share buybacks was what contributed
to the bear market. Well, buybacks have since been allowed in India, but
few companies have come forward with buyback plans. Marketmen now say that
the restrictions that hedge in buybacks are too severe.
For example, all shares that are bought back will have to be extinguished, which means they can't be issued again. If this restriction wasn't there, companies could buy their own shares when they are underpriced and sell them when they're overpriced, making a tidy profit. The counter-argument, of course, is that managements would abuse their position, using insider information to manipulate share prices. And secondly, companies that go for buyback have restrictions on tapping the market for more funds. Small wonder that companies are not too keen on buybacks.
But that's not the real reason
Note that the real reason could be very different. At a time when share
prices are down it makes sense for company managements to signal the
intrinsic price (at which they believe it should trade) of their shares by
announcing a buyback when the scrip goes below that price. When prices are
quoting at very high valuations, company managements are reluctant to
offer buybacks at high prices.
Why is that? Because the real question should be: is a stock buyback the best use for the company's money? In other words, could the company have received a higher rate of return if it had invested that money in some other asset besides its own stock? Analysts say there's a simple way to find that out.
Buyback should depend on intrinsic value of a stock
This is what an analyst has to tell company management. "The rule is to
buy back stocks is that as long as you are buying your stock for less than
its intrinsic value, you are creating more value for shareholders.
Intrinsic value is what a stock is worth, based not on temporary
stockmarket bullishness or bearishness, but on the business prospects of
the company. The moment you start paying a premium to buy back your stock,
you are destroying value. You will then be using company money to buy an
asset which is going to lower your rate of return."
Of course, there may be differences about what a company's share is intrinsically worth. Nevertheless, it can be said that in bull markets, when values are inflated, it doesn't make much sense to go in for buybacks. It's the same as using shareholder money to buy an asset at an artificially high price, thus losing money in the process.
ROCE is a good indicator
The simplest benchmark one can use to see if a buyback adds value is to
compare the ROCE (Return on Capital Employed) of the company with its cost
of debt. If a company has a ROCE in excess of its cost of debt, it makes
sense for the company to take on debt and buy back its equity. This is
neither a sufficient condition in itself or for that matter a necessary
condition. But ignoring all other factors for the moment this is the best
criterion to judge if a buyback adds value or not.
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Article 4:
About stock splits
Investors must have read a lot on stock splits in newspapers of late.
There have been several stock splits in recent times. Not to mention the
spiralling stock prices due to stock splits. Ever wondered what actually
does a stock split do? A faintly similar thing is bonus. How does that
work?
In theory, a stock split shouldn't affect market capitalisation
Let us take the stock split of Infosys as an example. The company split
its share into two. If the pre-split price of a share is Rs10, and the
stock is split two for one, then, theoretically speaking, the price of the
new (split) share should be Rs5. That's because the company's net assets
do not increase, only the amount of its outstanding shares goes up. But
life is vastly more complicated than theory. In the Infosys' stock split,
the market was expecting five shares for one; the two-for-one ratio
disappointed it and the stock plummeted after the split was declared.
Theoretically, a stock split is a non-event. The fraction of the company that each share represents is reduced, but each stockholder is given enough shares so that his or her total fraction of the company owned, remains the same. The split should not change market capitalisation.
But it often improves sentiment for the stock
In practice, however, market cap does change. A split often drives the new
price per share up, as more of the investing public is attracted by the
lower price. A company might split when it feels its share's price has
risen beyond what an individual investor is willing to pay, especially
when the shares are bought and sold in marketable lots. Even when the
shares are traded in the demat mode, where even one share may be traded,
the price may be high enough to discourage small investors. A shining
example is Infosys again. The stock was trading at almost Rs10,000 prior
to its split. (Of course, it has almost doubled since then, and is quoting
at the same level post-split! But that is a different story).
It attracts small investors and increases liquidity
Another reason frequently offered for a stock split is that it increases
liquidity. Because the number of shares increases, the amount that
investors are willing to buy or sell also goes up. For instance, an
investor may be willing to buy one share of Rs5000, but may not venture if
the share price is Rs10,000. Companies sometimes want to attract
individuals to stabilise the price, as institutional investors buy and
sell more often than individuals. That's yet another reason for a split.
What about bonus?
Bonuses have a long history in India. A bonus is nothing but
capitalisation of the issuing company's free reserves. If a company has a
capital of Rs100, and reserves of Rs100, it can issue bonus shares of
Rs100. In its balance sheet, the company's capital will then (post-bonus)
be Rs200, while reserves will be nil. The net worth of the company will
not have changed in any way.
So, here too, the price of the single share should diminish, depending upon the bonus ratio. Again, in practice, a bonus issue is a way of the company to reward its shareholders. It is also a sign that the company is healthy. That's because while nothing may have changed for the shareholder, the company has the responsibility of servicing the new shares.
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Article 5:
Of defensives and cyclicals
Cyclicals and defensives are possibly some of the more frequently used
terms (or is it jargon?) in the stock market. Ever wondered what these
mean? And why are these called so?
Stocks are sometimes divided into two broad categories - defensives and
cyclicals. The dividing criterion is a stock's response to business
cycles. So, to understand which stock is defensive and which is cyclical,
we will first have to know what is a business cycle.
It is well-known phenomenon that while an economy grows over a period of
time, this growth is far from smooth. At the same time, the trend is not
hopelessly jumbled or random. What is striking is that growth seems to
occur in cycles, usually well-defined cycles.
Economy moves in cycles...
Take the start of an upturn. Business picks up, orders increase, demand
increases and piled-up inventories start getting run down. The climate
slowly improves till sales growth zooms, profits follow, and all the
capacity in the economy gets used up. That's the time when demand for
investment picks up. New factories start getting built, new machinery
start getting ordered. At this stage of the cycle, business is booming.
And the cycle repeats...
The over-optimism results in too much capacity being built up. Demand
fails to keep pace with the supply of goods and services. The high costs
of new equipment and new capital expenditure weighs on companies. Profits
start getting squeezed and the downturn in business activity starts. Soon,
the rate of growth of profit contracts, business sentiment is dampened,
excess capacity is widely prevalent in industry, there are job losses, and
demand shrinks. This is recession, and business continues to remain
depressed until the next upturn.
Why do business cycles occur?
Economists have advanced several reasons. Among the most convincing is the
one advanced by Lord Keynes: that there is no stabilising mechanism in
economy that equates savings to investment. That's because those who save
are not necessarily those who invest. So, there'll always be a gap between
savings and investment. For instance, if there's too much savings, then
not enough will be spent on consumption, and demand will suffer. He said
that the government must step in to increase effective demand when there
is excess capacity in the economy.
Many companies have fortunes linked to these cycles
There are industries that are cyclical. A very high sensitivity to the
business cycle is what distinguishes them. For instance, commodity prices
move up with the cycle and down with the cycle. That's pretty obvious,
because the demand will depend on the level of business activity. So, all
commodity stocks are cyclicals. Or take the banking sector, which is a
clear play on the economy. Banking profits depend very much on the level
of business activity in the country. Banking stocks are very cyclical.
Companies selling luxury goods, such as diamonds, are also very much
affected by the state of the economy.
A select few escape the cycles
All companies are affected to a greater or lesser degree by business
cycles. Those that are relatively insulated are known as the defensives.
For instance, fast moving consumer goods (FMCG) companies cater to the
basic necessities of people. People need to buy food (or brush their teeth
for that matter) irrespective of whether there's a business cycle or not.
So, the earnings of these companies are less affected even by an economic
downturn. Or take pharmaceuticals, an industry that has practically no
relation to business cycles. Medicines are a necessity for people, and
companies selling medicines are more or less insulated from the level of
business activity in the economy. That's why the FMCG and the pharma
stocks are known as defensives.
Some depend on business cycles of other economies
The export sector is also insulated from the domestic economy. Its
fortunes are linked with those of the economies to which it exports. For
example, the diamond industry in India, although a cyclical one, does not
depend on Indian business cycles but rather on the European or American
ones. India's infotech companies too are mostly dependent on US demand.
So, a crash in the US could affect them badly, but they are immune to
Indian business cycles.
So there you are! Now you know why a company like Hindustan Lever or Glaxo will be largely immune to the ups and downs of the economy. And hence, belong to the defensive category. On the other hand, the fortunes of Reliance Industries, a global petrochemical giant by all means, are determined by the petrochemical price cycles. Which is why it is called a cyclical.
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Article 6:
Everything about bonus...
If you've attended any annual general meeting of any company, one issue
that shareholders never fail to sally forth - other than the demand for
higher dividend - is "Chairman saab, is saal kya bonus issue offing me hai?"
("Mr Chairman, is there a bonus in the offing this year?"), which
sometimes also takes the sarcastic tone of "bahut deri se aap ne hum
chhote shareholders ko koi bonus nahi diya?" ("it's been a while since you
gave us small shareholders bonus shares?").
The big "bonus" question seems so important to most shareholders, we thought we should evaluate why they make this supernormal demand. But before we get into the relevance of a bonus issue, we'll touch upon what a bonus issue is, and why companies have been issuing bonus issues since time immemorial.
What's a bonus issue?
Bonus is an issue of free shares by a company to its shareholders in
proportion to their existing holdings. In short, it means that the company
has turned part of the profits and reserves to capital. So while the
reserves stand reduced, the capital has increased.
For example: You own 100 shares in a company and the current price is Rs1,000 per share. If the company announces a '1 for 1' bonus issue and issues you 100 more shares, you now own 200 shares. Does that mean your holding doubles in value? No, because the market will adjust the price of the shares so that the total value of your holding remains what it was before. In the above example, the share price would adjust to about Rs500 per share, so you still have a holding worth Rs100,000. Similarly, the dividend per share will adjust pro rata. Suppose company A, with an equity of Rs60cr and reserves of Rs120cr, announces a 1:1 bonus, there is no change in the net worth but the earnings per share changes. But hold on, the change has been to the extent of the change in the share price. So, effectively, there is no change in the share value of the shareholder.
What good a bonus issue does
Wait, there may be something positive about a bonus issue. Let's dwell
into this argument further and provide reasons for the relevance of a
bonus issue. The main objective of having a bonus issue is to make the
shares more marketable. With more shares in circulation and a lower share
price, a company expects better liquidity and higher investor interest in
its shares. Let's take the example of MRF's shares, which see little
activity owing to the illiquid nature of the stock (the company's equity
is only Rs4.24cr). But if MRF were to issue a bonus issue the liquidity in
the stock would improve. Also the company is trying to signal that it is
now capable of servicing a large shareholder base.
Picking the finer points
So far, so good. But the important question is: is that company capable of
servicing a large customer base? If so, can it maintain its dividend
ratio? Remember, next year, the company would have to shell out a large
part of its profits to the shareholders, even if it maintains it previous
dividend ratio.
And if it does maintain its ratio, it is possible that the company might be putting back a relatively smaller part of profit back into the business. And this in turn might have other implications on the company. Let's take the case of Century Textiles. The company issued its fifth bonus issue in 1997. The bonus of 1:1 was issued to reward its shareholders on its 100 year of operation. But the point is the company was well aware that it would not be able to service its customer base and would not be able to continue with the dividend ratio. The net result: the following year, the dividend ratio fell by 60 percent to 10% and is today giving a dividend of just 6%.
Bonuses are like pizzas
The two examples above amply demonstrate that on its own, the bonus issue
has no relevance if it isn't serviced well by the company. Even from an
investor's point of view, a bonus share issue does not add up to capital
appreciation. An investor may still be motivated because the investor is
hopeful that his next dividend will fetch him higher returns. But like we
have already seen in our earlier example, much depends on the performance
of the company.
Remember: a bonus issue is like a pizza. You could cut it into as many slices as you want, it still won't increase the size of the original pizza. Also, like a pizza, enjoy your bonus issue, but take it with a pinch of salt!
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Chapter 2:
On Stock Markets
(Ever wondered how the budget affects the stock
market?)
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Article 1:
Limit Order
Ever overheard a typical conversation between a broker and his client?
Here is an excerpt of what it is usually like?
Client: What is the market rate of Infosys? Broker: Quoting Rs7,500/505? Client: OK, buy 100 shares of Infosys? What will the broker do now? He will buy Infosys shares in the market at any (the best) available price till he has a 100 of them. By buying shares for his client in this manner, the broker just executed a 'Market Order'.
What is a Market Order?
A 'Market Order' is an order to buy or sell a stock immediately at the
best available price in the market. Sometimes it is referred to as an
'Unrestricted Order', since it comes with no conditions attached from the
client.
Hence, it is the simplest order that can be placed in the market. The client just informs his broker to execute the trade and the broker executes the trade at the best price available in the market. Interestingly, it is the only order that guarantees execution unless of course the 'circuit breakers' set by the exchanges come into play!
Hmm! Could anything go wrong here?
Imagine a situation where just as our client is placing his market order,
a big fund places a 'market order' to buy 20,000 shares of Infosys!
The price is soaring through the skies and in the melee our client manages to buy his 100 shares of Infosys at Rs7,700! Our client is caught completely unawares. Since the client thought that he was buying just 100 shares, he would have assumed that his trade would get executed very close to the market price of Rs7,550. In the end, he bought 100 shares a good Rs150 higher than expected. What if the client was playing it tight and cannot fork out the extra Rs15,000 that his 'market order' resulted in...? Is there any way of avoiding these hazards while placing an order? Hallelujah! Thank God for small mercies like the 'Limit Order'.
What is a Limit Order?
An order placed with a broker to buy or sell at a predetermined amount of
shares at a specified price or better than the specified price.
So how would the conversation of our client with his broker have gone if our client knew about 'Limit Orders'? Client: What is the market rate of Infosys? Broker: Quoting Rs7,500/505?. Client: OK, buy 100 shares of Infosys at Rs7,550. What will the broker do this time around? He will buy 100 shares for our client at a price of Rs7,550. In case a fund places a big 'market order' to buy 20,000 shares of Infosys on the same day and in the process takes the price to Rs7,700, our broker will wait for the price to come back to Rs7,550 before buying shares for our client.
Know the limits of a Limit Order
A good question may crop up at this stage: What if the price does not drop
below Rs7,700 at all? Well, what can we say? Our client missed an
opportunity to probably make a decent profit on Infosys? ! Too bad.
In other words, there is a flip side to using a 'Limit Order' vis-?is a 'Market Order'.
Which one, when? That depends on your timeframe
This depends on your time horizon. In case of our client, it depends on
what he is buying the 100 shares of Infosys for. If he is buying these 100
shares with the intention of selling them within a month at Rs8,500, then
it makes a lot of difference whether he buys it at Rs7,550 or Rs7,700.
On the other hand, if he is buying these 100 shares with the intention of holding it for the next five years during which time he hopes to sell it at Rs15,000, then the difference of Rs150 a share he sacrifices now pales in comparison to the profit of Rs7,450-7,300 per share he hopes to make over this long period. In case the price never drops below Rs7,700, our client would have missed out on a Rs7,300 profit in 5 years because of insisting on saving Rs150! Reminds us of the proverb " Penny wise, pound foolish." Of course, the knowledgeable amongst you would have figured out that 'Limit Orders' are more useful for the traders whereas the 'Market Orders' are more useful for the investors.
The tricky question is how do you set the limit for a 'limit order'?
The limit can be set based on your perception of what is the right value.
After all, we have our own perception of value when we buy shirts or
vegetables. This goes for stocks as well!
For traders, the limit price depends on the potential profits they see from that level, and their risk-reward playoff. By the way, limit orders allow an investor to limit the length of time an order can be outstanding before cancelled. A quick look at the various limit orders that can be placed: End of Day: Any order to buy or sell a stock that automatically expires if not executed on the day the order is placed. Good till Date: Any order to buy or sell a stock that automatically expires if not executed on the date specified when the order is placed or the end of the particular settlement on the exchange, whichever comes first. End of Settlement or Good Till Cancelled: Any order to buy or sell a stock that automatically expires if not executed by the end of the settlement on the exchange unless the order is cancelled during that period. Now that we have understood the basics of 'Limit Order', it is time to move on. Next, we will understand the 'Stop Loss' order better.
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Article 2:
Arbitrage between NSE & BSE
These set of transactions are probably the most badly understood
transactions. The financial dailies have added to its popularity by just
displaying closing price differences between the two exchanges to
highlight profit making opportunities.
But they are misleading as very few shares actually change hands at that price. But to top it all these transactions are not 'arbitrage'! The fact that you use the word 'arbitrage' must mean that the transaction is riskless and hence safe! Are these transactions really riskless? The arbitrage between NSE and BSE has two parts to it. In the first stage you sell on NSE and buy on BSE at the end of settlement (Tuesdays of every week) and then reverse the transaction on the very next trading day (buy on NSE and sell on BSE). Why does arbitrage need to be executed in two phases? The first part leaves an open position on two different exchanges with not only two different settlements but also two different settlement standards. Hence, you need to get your delivery from BSE and deliver at NSE. One goof up somewhere would mean 'auction' and 'penalty'. What was meant to be a 'free' lunch can end up being a very 'costly' luncheon. However, it's true that with dematerialisation the risks of delivery have been mitigated to a large extent Once you have two parts to the transaction, you are still taking a risk- an overnite price risk. After all, prices can change sharply the following day on both the exchanges. You can say that you are betting on relative price differences between BSE/NSE and these could move in tandem after all. But what if the stock hits the lower circuit or the upper circuit? You can buy on one exchange but cannot sell on the other or vice versa. Gosh! You cannot complete your transaction and might get saddled with the position! In short, this is not 'arbitrage' as it is not riskless. Unable to coin a better term people called it so. It is a misnomer.And it probably makes sense for a broker to indulge in such so called 'arbitrage' transactions. For normal traders, it does not make sense paying brokerage four times and still carry out the transactions between the exchanges. A better option is to arbitrage between futures and the cash market or just take part in 'vyaj badla'.
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Article 3:
Fiscal policy and the markets
No escaping the fiscal deficit
There's no escaping the fiscal deficit. The thing has escaped from the
pink papers, where it rightfully belongs, to the ordinary newspapers. The
investor has enough on his mind tracking his portfolio, so why does he
need to bother about the fiscal deficit?
Think of the government as the biggest player in the financial markets. That's the reason why we lesser mortals have to bother about it. It's a bit like the Unit Trust of India. When the UTI got into trouble last year, the markets took a tumble, and then waited with bated breath for UTI to get bailed out. And the government is many many times bigger than the UTI. Sure, the government doesn't play the stockmarkets itself, except through its disinvestment programmes, but it controls the debt markets. The government's need for borrowing money to finance its expenses is nothing but another name for the fiscal deficit. No wonder it affects the entire economy.
Government borrowing affects the entire economy
How does it do that? Well, if government borrows too much, it "crowds out"
the private sector. The stock of financial resources (money) being
limited, excess government borrowing results in there being less left over
for the private sector. Also, when government borrowings increase, the
demand for credit increases relative to the supply for it. So the cost of
credit increases. The cost of credit is nothing but the interest you pay.
And when interest rates rise, that's obviously negative for companies, as
higher interest costs eat into profits.
Borrowing from RBI-a surefire recipe for inflation
Sometimes, the government does not borrow directly from the market but
instead borrows from the Reserve Bank. That's actually equivalent to
printing money, and is called, in the jargon, monetising the deficit. When
this happens, the amount of money supply increases and that makes price
rise as well. Don't get it? Well if we all had a printing press at home in
which we could print money then we could all become crorepatis. We could
afford to pay any amount to buy anything we wanted to. Everything then
becomes an auction and there is no limit on how high prices can go because
there is no limit on how much you can afford to pay-after all, you have a
printing press at home. But that is a surefire recipe for inflation.
When the government borrows from the RBI very much the same happens. Sure not all of us have a printing press. But this is one hell of a big printing press. So prices are bound to rise. And then the price that you pay for money (which is nothing but interest rates) begins to rise too up.
To keep deficit in check, government raises resources through higher
taxes...
The moral of the story is that the government should cut its coat
according to its cloth. How can the government do that? One easy way is to
raise resources. The simplest way to do that, as we are painfully aware,
is to increase taxes. Increased taxes takes away purchasing power from
people, thereby reducing demand. It also dampens the incentive for people
to work harder. During the bad old socialist days, marginal tax rates went
up to over 90%, leading to a flourishing black economy. These days,
thankfully, finance ministers realise that too much taxation is
counter-productive. But the point is, whether the government chooses to
tax more or not has implications for companies and therefore for the
markets.
...and that impacts stocks
While corporate tax rates apply equally to all companies, changes in the
rates of excise and customs duties affect different industries in
different ways. That's why we have all those analyses on budget day trying
to gauge the impact of the budget proposals on industries and individual
companies. Obviously stocks too are impacted.
Disinvestment-a resource-raising route which also affects market
The other way of raising resources is through disinvestment. Divesting the
government stakes in good companies brings good quality investments into
the stockmarket and helps investors.
Deficit can also be checked through expenditure cuts
But raising resources is not the only way to keep the deficit in check.
The other way is to reduce government expenditure. Is that a good thing?
It depends on the state of the economy. If there is a recession going on
and there is substantial excess capacity, reducing the deficit would
reduce purchasing power and hurt demand. The need here would be to
increase government expenditure to kickstart the economy.
The quality of the deficit is of great import
At other times, however, reducing government expenditure would be a good
thing. It depends, however, on what kind of expenditure you prune. If the
government cuts down on capital expenditure, that is the expenditure
required for building physical and social infrastructure, then economic
growth is bound to suffer. Government investment in roads, telecom, ports,
etc, has knock-on effects on the rest of the economy, improving
productivity and raising investment demand. That translates into orders
for capital goods companies. Growth obviously translates into growth for
individual companies, raising their valuations. If, on the other hand, the
government reduces subsidies, rationalises prices, and trims flab in an
effort to become more productive, that is to be welcomed. In other words,
it's not just the fiscal deficit that is important, but the quality of
that deficit.
State of government finances should concern investors
The government, through its fiscal policy, has the power to control the
economy, interest rates and with it, the direction of the markets.
Investors have reason, therefore, to be concerned about the state of the
government's finances.
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Article 4:
Monetary policy and the stock market
Monetary policy affects all of us
You would have noticed the reams of newsprint churned out when the Reserve
Bank of India announces its monetary policy every six months. Like a lot
of people, you would have thought that
The fact is that RBI monetary policy has an effect on all investors. Let's take a look how.
A tool to control inflation, which directly affects interest rates
Monetary policy is aimed at controlling the level of inflation & interest
rates in the economy. To do that, the Reserve Bank tries to lower the
money supply when prices are rising. How does it do that? By lowering the
amount of money available with banks. Raising reserve requirements, i.e.,
the amount of money which banks must keep impounded with the RBI, is one
way. Another method is to sell bonds to the banks. When banks buy bonds
from the RBI, money flows out from banks to the RBI, lowering the amount
of money available for lending. You'll remember that just before the 1996
election finance minister Manmohan Singh tried his best to lower
inflation, believing that a lower inflation rate would improve the chances
of a Congress government. He got that wrong, but in the process RBI
squeezed money supply.
What happened next is history. Because money was scarce, interest rates started moving up to astronomical levels. Companies found that they were starved of funds, or couldn't afford the high rates. The ultimate result was that the economy slid into a recession. So by changing the money supply, the Reserve Bank can determine the level of interest rates. Higher levels of interest rates impact corporate bottomlines and discourage companies from investing. That slows down growth.
Does the process work the other way?
In other words, can the RBI spark an economic recovery by increasing money
supply, with resultant lower interest rates? The evidence does not seem as
strong. Lower interest rates can help in creating the right atmosphere for
a recovery, but it is not enough to spark one by itself. Some kind of
stimulus to demand must go hand in hand as well.
Impact on stockmarket
In the West, where both the bond as well as the equity markets are mature,
an increase in interest rates leads to more money flowing into bonds.
Other things remaining the same that means less money for the equity
markets. You'll remember that late last year, when the Dow showed signs of
weakness, Federal Reserve Chairman Alan Greenspan decided to lower the
Federal funds rate and the discount rate. Lowering the rate at which banks
could access Federal funds was a signal for interest rates to go down in
the rest of the economy. Money flowed from the bond into the equity
markets, the Dow crossed the magic 10,000 mark, and Greenspan
single-handedly saved the world! In India, the bond markets are not very
liquid, and only the banks are active in that market. Since banks do not
invest in equities, except marginally, there is no flow of funds from the
bond to the equity markets. So the impact of monetary policy on the equity
markets here is indirect, rather than through the direct route.
There's yet another way in which higher interest rates affect the advanced economies. Because almost everyone in the US has borrowed up to his neck, interest rates are important for consumer spending. When interest rates rise, people spend less because they can't afford to borrow at the high rates. This lowers demand and slows the economy down. However, the RBI does have a more direct way of influencing the stockmarket. That is by varying the percentage of funds which banks are allowed to invest in the stockmarket. At present, the limit is 5 per cent of the incremental deposits of banks. That means, if a bank gets Rs100 worth of new deposits, it can invest Rs5 in the stockmarket. Unfortunately, with banks not being very keen on investing in equity, their investments been far below the limit.
RBI can also influence exchange rates
The central bank also has the power to decide the level of the currency
both by direct intervention and by targeting interest rates, which are a
key factor in determining exchange rates. If it feels the rupee is too
weak, it sells dollars in the market and buys rupees. If it feels the
rupee should go down a bit, all it has to do is buy dollars. The rupee's
exchange rate obviously has enormous implications for importers and
exporters. What's more, even those companies which produce for the
domestic market would be affected, because the price of imports would be
changed. For instance, Reliance Industries would benefit if the rupee
becomes stronger, as the price of competing imports would rise. Similarly,
companies which export software would benefit when the rupee weakens.
Well so the next time the newspapers devote reams of newsprint to the monetary policy, scan it well-it has serious implications on the stock market.
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Article 5:
The MSCI Index MSCI's index changes may see India's
weight dip -FE 16/5/2000
India's weight may be hit as MSCI overhauls systems - ET 16/5/2000
MSCI index to cut India weightage
- BS 16/5/2000
Yesterday, all the financial newspapers highlighted a possible revision
of MSCI's world index and a cut in India's weightage from the present 9%
to 3%. But what is MSCI and why are people concerned over a possible
revision of its indices?
Who is MSCI?
Morgan Stanley Capital International Inc. (MSCI) is a leading provider
of global indices, benchmark related products and services to investors
worldwide. MSCI indices are the most widely used benchmarks by global
portfolio managers.
According to a recent survey by Merrill Lynch/Gallup, over 90% of the North American and Asian international equity assets are benchmarked to the MSCI Indices. In Europe too, over 50% of the continental fund managers peg their portfolios to the MSCI Indices. Besides this, the MSCI has 1200 customers worldwide who use its indices as a benchmark. Hence any change in these indices has a significant impact on global capital markets.
What does it mean to be a benchmark?
How does the global fund manger decide where to invest his money and in
what proportion (asset allocation as they call it)? He needs a benchmark
that indicates the available investment opportunities around the globe.
The benchmark is typically an Index. The most popular global indices are the MSCI indices. The MSCI Indices (there are a basket of them) consist of various stocks from individual countries. The global fund managers can then benchmark their performance in two ways. Either they can mimic the entire portfolio of stocks and hence peg the return to that of the index or they can choose some other stocks that can outperform the return of this index. Hence the portfolio manager's investment patterns are determined not just by how attractive the companies in your country are but also by the weight of your country in the MSCI index.
How is the index generated?
The MSCI equity indices are constructed in a consistent manner across
all countries, encompassing a total of 23 developed markets and 28
emerging markets. This consistent approach to index construction ensures
proper representation of the country's underlying industry distribution
and market capitalization. It allows investors to accurately compare
equity performance across markets, regions and sectors.
In this process, MSCI tracks developments in almost 3000 companies (both listed and unlisted) around the globe. These equities account for over 99% of the world's total market capitalization. MSCI country equity indices are constructed using the following five steps:
Powerful enough to affect country's capital market
It is very difficult for any global fund manager to track the whole
world's equity market and optimize the profit of his portfolio. MSCI
Indices cover almost 99% of the entire world's market capitalization;
therefore almost 90% of the global managers from North America and Asia
follow these indices for their investment decisions.
Here's the clincher. If MSCI revises weightage of any country in the MSCI world index then most of the global managers react to it and shift their investments correspondingly. For example, if MSCI announces any dip in the India's weightage in the world index and increases say Thailand's weightage, then global managers will decrease their exposure to Indian stocks and the money will shift to Thai stocks. Hence, these revisions of country's weight in the index can cause huge sums of capital to either flow in or out of a country changing the fortunes of its capital market.
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Article 6:
Meet the Sensex
What is a stock index?
Probably, the first thing you ask your broker when you ring him during
market trading hours is: where is the market? What does he mean when he
says it is up 25 points (say)? He is referring to the Sensex being up by
that much. Now one assumes you already knew that anyway. But do you know
what the Sensex represents exactly?
The Sensex is a stock index that represents changes in values of share prices of a select group of companies over a base period.
The many uses of a stock index
The companies included in any stock index are generally leaders and
representatives of their respective industries. Hence an index as a whole
represents the wellbeing of the most important industries in an economy.
And since industrial performance is a proxy for determining the state of
an economy, we could say that the stock index itself also echoes the
economic welfare of a country.
The index also acts as a barometer for market behaviour. So if the index value goes down, it means the market is bearish (selling, therefore not optimistic of an upward trend) and if it goes up then it is bullish (buying, in the expectation of a rise based on positive news/performance). An index can be used to benchmark portfolio performances. In our write-up on MSCI indices, we saw that almost 70% of the global managers benchmark their portfolio returns against MSCI indices' returns. Now in order to benchmark a portfolio or to evaluate the economy using the stock index, we need for it to have a value. We know that, for instance, both the Sensex and the Nifty possess values that change daily.
What a Sensex value represents
As per the definition of an index, a Sensex value of 4600 and Nifty value
of 1400 (say) represent the change in the collective value of the share
prices of select companies over a base period.
The BSE Sensex came into existence in the year 1979 with a start value of 100, whereas the NSE Nifty was born in year 1991 again with a start value of 100. That means the value of the companies in the Sensex has increased 42 times in 21 years, while the value of the companies in Nifty has jumped 14 times in 10 years.
Criteria for choosing Sensex companies
Moving to the next question that Sharekhan senses burning in your mind: On
what basis is a company elected to be in a stock index? Why does the
Sensex include an Infosys and not a Wipro? Here's what companies must have
to play a part in any index:
Market capitalisation: The company's scrip should figure in the top 100 companies listed by market capitalisation. Also market capitalisation of the scrip should be more than 0.5% of the total market capitalisation of the index i.e. the minimum weightage in the index should be 0.5%. Industry representation: Scrip selection would take into account a balanced representation of the listed companies. The index companies should be leaders in their industry group with sound management. Scrip group: The stock should preferably be from the A trading group. Trading frequency: The stock should have been traded on every trading day for the last one year. Number of trades: The stock should be among the top 150 companies listed by average number of trades per day for the last one year. Number of shares: The scrip should be among the top 150 companies listed by average number of shares traded per day for the last one year. Trading activity: The average number of shares traded per day as a percentage of the total number of outstanding shares of the scrip should be greater than 0.05 % for the last one year. Financial track record: The company should have either a consistent dividend paying record or a good profitability record. Wipro does qualify on some criteria, such as the market capitalisation and being industry- representative, but on account of its low free float, it stays out of the Sensex. In contrast, Infosys qualifies on market capitalisation as well as liquidity and hence it forms a part of the Sensex. Sensex companies are continuously monitored on the above characteristics and if in any year, a company does not satisfy all conditions, it is replaced by another company that does have all defined characteristics.
The magic of 100
In 1979, BSE decided to start Sensex (BSE-30). For this, it added the
market capitalisation of all the selected thirty stocks at that time and
divided the sum by a unique number to make the Sensex amount to a value of
100. This unique number is known as base of the Sensex.
This base is a very dynamic number and its value keeps changing with the changes in the composition of the Sensex or with the any change in the included companies' equity. Hence for all rights issue and any other change in the equity of the composite companies, the base of the index is adjusted so that the value of the index does not get destroyed. Our Sensex is based on the market capitalisation of stocks that form part of the index. The greater the market capitalisation of a company, the higher its stock's influence on the Sensex movement. So, in the current scenario, an 8% increase in Infosys' share price affects the Sensex more than an 8% increase in Grasim's share price. But market capitalisation is not the only possible influential factor. There are some more possible factors that can move the index, but before getting into that, we shall leave you to absorb the above. Happy musing!
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Article 7:
Stock Auctions
Of auctions and their origin
The word auction, in simple terms, implies a public sale in which property
or items of merchandise are sold to the highest bidder.
Did you know that auctions used to take place way back during the Homeric period in Greece? It was a means of transferring the ownership of slaves from one person to the other. This same underlying concept of auction has taken a more refined form in recent times - like the auction of commodities or the belongings of famous personalities. Have you ever been to an auction house like Christie's or Sotheby's, where works of art are sold to the highest bidder in auction? Now, you are probably beginning to wonder what we are doing discussing auctions of slaves and commodities or art auction houses like Christie's and Sotheby's here, in the investment jungle! Allow us to clarify that our intention is not to discuss art auctions per se, but auctions conducted on the bourses. Auctions are not conducted only to sell merchandise or works of art in big auction houses; they are also a common feature on stock exchanges.
Why conduct auctions in the stock market?
Auctions are conducted on the exchanges when, for some reason, shares
(physical or demat) are not delivered to the exchange on time.
Exchanges conduct auctions to penalise the party for defaulting on delivering the shares on time, and thereby to protect the sanctity of settlements. It is a necessary evil - imagine the chaos if the defaulting party went scot-free and delivered shares at its own free will. This would trigger a chain reaction of defaults. If the defaulting party fails to deliver the shares on time to the exchange, the exchange in turn is unable to deliver the shares to the party who purchased them. The purchasing party in turn might have already sold those shares before receiving them from the exchange and now it would be unable to deliver those shares on time. This vicious chain could go on and on. Therefore, it becomes imperative that auctions are held so that pay-in and pay-out of shares take place on time, in accordance with the settlement cycle of the respective exchanges.
Reasons for shares to go on auction
Shares come under the hammer when they have been either delivered short or
found to be objectionable by the exchange. Based on the reasons why shares
qualify for auction, they have been categorised into two types:
Auction due to shortages
As has been discussed above, an auction due to shortages takes place when
the delivering party fails to deliver its share on time to the exchange,
thereby triggering the vicious chain reaction of the exchange being unable
to deliver the shares on time to the purchasing party and purchasing party
in turn being unable to deliver shares on time if it has already sold it
and so on... One of the common reasons why shares come under auction due
to shortages is the confusion that arises about the delivery date of the
shares, if they are going into the 'no delivery' period.
Auction due to objection
Physical shares go in for auctions not only if they are delivered short,
but also if they are found to be objectionable and not rectified on time
by the party concerned. There are many reasons why shares could come under
objection. To list a few:
When a share is returned to the broker by the exchange as objection, the broker is liable to inform the client and get the objection rectified. If the party fails to rectify the objection within a stipulated time period, then the shares go for auction. The defaulting party is then penalised by having to bear the auction price.
Does one always suffer a big loss in an auction?
The defaulting party does suffer a loss when their shares go in for
auction. Imagine the rate at which the auction would take place if the
market is rising and there is a great demand for the stock. The defaulting
party would be required to pay for the difference between the higher
auction price and the actual sale price of the stock.
Even in the case of a falling market when stocks are taking a beating, the defaulting party does not stand to gain the difference in the auction price and the actual sale price. The defaulting party instead has to forgo the entire sale proceeds it had earned. Or even worse is the case when there are no participants in an auction. In such a case, the auction price is decided by the exchange. It varies with exchanges and is called the 'close-out' price.
How is the close-out price arrived at?
In three simple steps.
Step one: The exchange decides upon a 'fixed' price and adds 20% to it. Incidentally, the fixed price varies with exchanges. For the Bombay Stock Exchange the fixed price is the 'standard rate/ hawala rate' decided by the exchange. This standard rate is calculated on the last day of the settlement. It is the simple average of all the trades executed on that particular day. The National Stock Exchange, on the other hand, takes the closing price of the stock under auction as the fixed price. The closing price is arrived at by taking the weighted average of all the trades executed in the particular scrip in the last thirty minutes of the trading session. Step two: The resulting price is then compared with the highest price for the stock in the settlement in which the defaulting party sold the scrip. Step three: The higher of the two prices, ie the settlement price and the fixed price plus a 20% premium, is considered as the close-out price. Which means if the fixed price decided by the exchange is higher than the settlement price, the settlement price is deemed as the close-out price. Alternatively, if the settlement price is higher than the fixed price, the stock is 'closed out' at the settlement price.
Understand things with Reliance
Let us understand this better with an example. Let us assume that a
party has defaulted on shares of Reliance Industries (RIL). And his
shares are up for auction on the BSE. The BSE 'fixes' the 'hawala' price
for RIL at Rs320. And as per rule, it also adds 20% to the fixed price
and arrives at the final price of Rs384.
Let us make another assumption at this stage. That the highest price in the settlement in which the defaulting party had sold the stock, was Rs400. Now, obviously, the close-out will take place at the settlement price of Rs400, as it is higher than the fixed price (Rs384).
Other side of the coin
What if the settlement had taken place at a price less than the fixed
price of Rs384? What if it had taken place at, say, Rs305? Well, then
the fixed price will be taken as the 'close-out' price as it is higher
than the settlement price. And the stock will be auctioned at Rs384.
By now you must have got a fair idea about the kind of losses and inconveniences that one is forced to face if his shares go into auction. Which is why it becomes imperative that as responsible market players we maintain the sanctity of settlements by ensuring our shares get delivered on time.
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Chapter 3:
The rest
(Everything else you wanted to know...)
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Article 1:
For mutual benefit
How does a mutual fund make money?
Investing in a mutual fund is easy. All you have to do is to buy shares of
the fund (called units) and become a shareholder. Your money, pooled with
money from other investors, is what constitutes the fund. These funds are
then invested by a professional money manager in various stocks, bonds
etc.
So how does a mutual fund make money? In two ways: by earning dividends or interest on its investments and by selling investments that have appreciated in price. The fund pays out, or distributes, its profits (less fees and expenses) to its shareholders. That's how you make money. Most funds offer investors the option of reinvesting their distributions in the fund by buying more shares.
Why invest in a mutual fund?
Well, there are several reasons. First, since a fund can own hundreds of
different securities, its success or failure is not going to be dependent
on how well a handful of securities perform. In other words, a mutual fund
is well diversified. Spreading your money in this way among many different
companies and industries effectively reduces your risk-it reduces the
possibility that you may lose money. This diversification is one of the
biggest advantages of mutual funds. For most of us, the amount of income
and investment knowledge required to accomplish similar diversification
would be impossible to obtain. Also, sharing expenses with millions of
like-minded investors, through a mutual fund, significantly reduces your
investment cost. That's because a mutual fund is an "institutional trader"
and can therefore buy securities at wholesale prices. There's also an
additional reason for investing in mutual funds now. The dividend in the
hands of the receiver (that means you!) is tax-free.
By investing in a well-managed mutual fund, you share the expense of hiring a professional money manager with a proven track record. Your Rs500 will receive the same attention, and get the same returns, as the money of institutional investors, who place billions of rupees a year.
Choosing the right fund is critical
There are other benefits. You don't have to bother with the task of
keeping a record of your investments. Your investment is liquid, at least
for open-ended funds, and you can surrender your units to the fund and get
your refund within a few days. Of course, not all funds are equally
liquid, which is why choosing a fund is so important.
Before you buy units in any mutual fund, it is important that you know exactly how much it is going to cost. All mutual funds charge a management fee. It doesn't matter if you buy from a bank or a broker, you will pay a management fee. These fees are usually given as a percentage of the fund's total assets and pay the administrative costs and the wages and bonuses of fund managers. In addition, some mutual funds charge a "load" when you buy or sell your mutual fund units. A fee when you buy your units is known as a front-load, and if the fee is on redemption, it is known as a back load.
What is the Net Asset Value of a fund?
The net asset value of a mutual fund is the rupee value of one unit of the
fund and is calculated by dividing the current market value of the fund's
assets, less liabilities, by the number of units already sold. For
example, if the fund you are interested in has assets worth Rs20cr, after
deducting liabilities, and there are 1cr units already sold, each unit is
worth Rs20 (Rs20cr divided by 1cr). This means you would pay Rs20 for one
unit of the fund, and the NAV is Rs20.
The only way the NAV will change is due to the rise or fall in the market value of the assets held by the fund. Let's say that the same fund's assets increased to Rs30cr due to some great investment decisions of the fund manager and the number of units outstanding (sold) remained unchanged at 1cr. The net asset value of each unit you held would now be worth Rs30 (Rs30cr divided by 1cr). Anyone now buying into the fund would have to pay the new NAV of Rs30 per unit. If you decided to sell, you would have made a capital gain of Rs1,000. On the other hand, if you decided to stay with the fund, this capital gain would be paid out in the form of a distribution of the Rs1000, or be reinvested in additional units. Once distributed, or converted into additional units, the NAV will fall. Clearly, the NAV will fluctuate according to the market value of the stocks and bonds the fund has invested in.
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Article 2:
A wide choice
A wide choice
The investment pages of any pink newspaper will give you the lists for
scores of mutual funds. The variety is mind-boggling. You can take your
pick from open-ended funds, close-ended funds, debt funds, money market
funds, tax planning funds, balanced funds, gild funds et al.
But before you put your money into any of these, there are two important things to remember. These are the fund's investment objectives, and its level of risks. You'll first have to decide what your investment objectives are, and then see which fund matches those objectives.
Investment objectives
Every mutual fund has a specific investment objective. A fund that seeks
to provide safety of your principal amount or capital as its main
objective will obviously invest very conservatively, preferring safety to
risk. Income funds, on the other hand, will aim to provide investors with
stable and regular payments in the form of a monthly or quarterly cheque.
Funds that have growth as their objective will invest in equities to
increase the value of the fund's assets and provide investors with
long-term capital gains. Some funds seek to balance the objectives of
income and growth in one package.
Risk
Simply speaking, risk is the possibility that an investment may go down in
value or not perform as well as expected. Even your savings bank account
is subject to erosion on account of inflation. While government securities
are free of credit risk, they are exposed to market risk. We take a look
here at the varieties of risk:
Credit risk: This is the possibility that the company holding your money will not pay the interest or dividend due, or the principal amount when it matures. Interest-rate risk: The possibility that a debt instrument, such as a bond, will decline in value due to a rise in interest rates. Market risk: The risk that the value of your investment will decrease, as prices fluctuate in the market.
The risk-reward trade-off
Now for the trade-off between risk and reward. The simple rule is: The
higher the risk, the bigger the potential reward.
So how much risk should you be taking? It depends. If you're young or can afford to lose money, then you can take more risks. The older you get, or the less financially well off you are, the less risk you can take. Historically speaking, stocks have outperformed other financial instruments over time.
Kinds of funds
There are two broad categories of funds: open-ended and
close-ended. Close-ended funds are those which have a fixed date for
winding up. A close-ended fund for five years will, for example, return
all its money to unitholders after five years. These funds collect
subscriptions at one point of time, run for a fixed period, and are then
redeemed. In contrast, an open-ended fund has no fixed redemption date.
Instead, these funds will buy and sell units to the public continuously,
at a price announced by the funds and linked to its NAV.
Within these two broad categories, you can have several different types of funds. Money-market funds invest primarily in treasury bills and other very short-term instruments, such as commercial paper. Such funds usually pay a few percentage points more than savings bank deposits and have very little downside risk. UTI's MMMF, for example, has earned a return of 10.67 per cent in the last year. Fixed income or debt funds invest in some combination of treasury bills, debentures, and bonds. The aim of fixed income funds is to provide high, regular income payments with the possibility of some capital gains. Gilt funds are those funds which invest only in government securities. Safety is obviously the main objective of such funds. But while there is no question of the government defaulting on its own bonds, it is also a fact that the market prices of these bonds fluctuate. So while you may not be exposed to credit risk, market risk is very much a factor to be reckoned with. Growth or equity funds invest in ordinary shares of Indian companies and are recommended for investors seeking long-term growth through capital gains. An investment time frame of at least five years is generally recommended for this type of fund. Balanced funds provide a combination of income and growth by investing in a mixed portfolio of stocks, preferred stock, bonds, and money market instruments. Index funds are funds whose investments replicate a benchmark market index, including the weightage of different stocks in the portfolio, so that the performance of the fund mimics the movement in the index.
Factors to consider while picking a fund
First, assess the level of risk you are comfortable with and pick a fund
which has the same investment objectives.
Second, consider the track record of fund managers. It is important that you check the long-term track record to eliminate the possibility of a flash in the pan. Third, choose low-cost funds.
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Article 3:
Interest Tax Shield
In the Utopian world where there are no taxes and no risks of bankruptcy
either, the value of a firm is independent of its financing decisions.
While use of debt increases the overall returns to the shareholders (due to leveraging), the increase in returns come at a higher risk. So firms opt for the use of debt so long as the addition to risk is within limits. Thus the liability side of the balance sheet is not the primary determinant of returns. The money that is made is dependent on the firm's operations - that is, on the asset side. In the real world, there are taxes that need to be compulsorily paid, debt increases the overall income that is derived from the firm's operations. How? Assume that a business is funded with Rs150 of capital and it generates a profit before interest and tax (PBIT) of Rs25. Here is how the pay-off looks in a zero tax world. Assume that the interest rate is 12%. Scene 1: Zero Tax
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Article 4:
Mortgage Backed Securities
A mortgage-backed security is a debt instrument backed by a pool of
mortgage loans. Investors receive payments from the interest and principal
payments made on the underlying mortgages. Typically, the way this would
happen is as follows...
Let us say (for eg) that Housing Finance Company (HFC) has financed a number of individuals for the purchase of a house. Now, a loan is a specific agreement between the company and the borrower. It is not a tradable instrument and is it not liquid. The capital of the HFC would be blocked in this loan till such time that it receives the sum back by way of repayment over the next 10, 15 or 20 years. HFC would then pool some of these loans together and transfer them into a separate legal entity. This entity would be entitled to receive the amounts due from the borrowers over the life of the loan. At the next stage, this new entity would then issue debentures or as it would be called in this case Mortgage Backed Securities (MBS), which are secured against the receivables from the borrowers. HFC would continue to manage this special entity that holds the pool of mortgage loans. The advantage to investors in the MBS is that they have not taken a direct loan exposure to a specific borrower. MBS permits HFC to create a self-financing mechanism for financing housing loans. Such a system enables the supply of housing finance to enlarge beyond traditional limits and hence expands the housing market itself. As for the government's initiatives to expand this market, we are not fully conversant with the nitty-gritty of any policy initiatives that the government has taken (or not taken) or of the legal reforms that are required to enable this product to be a success. But perhaps, there are some bankers or financers or lawyers out there who work in this field and might be able to shed more light on this subject.
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Article 5:
Of bonds and debentures Before we get to
differentiating a 'bond' from a 'debenture' , we need to understand one
thing. That when ever we buy a bond or a debenture, we are loaning our money
to an entity for a fixed period at a specified interest rate. So the entity
has a predefined commitment to pay a fixed sum to us unlike a company that
does not commit any specific dividend to a shareholder. |
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