Shyam's Column

Q&A: Deciphering Mutual Funds

2009-11-10T00:01:00.003+05:30

Infrastructure mutual fund schemes seem to be the flavour of the season. How good are they compared to other schemes available out there?

Try taking a look at the portfolio holdings of a typical Infrastructure focused mutual fund - I assure you that you’ll be in for a surprise. Clearly, the term ‘infrastructure’ has been very loosely interpreted (if it has been interpreted at all). How else would you describe the presence of Banking, NBFC and Real estate stocks in the portfolio?

Anyways, I am quite downbeat on funds that focus on any particular sector, because they defeat the purpose of investing in a mutual fund – which is to achieve diversification and reduce risk. Concentrating the fund scheme’s portfolio in one or two sectors increases risk of capital loss in the event of a bubble. While some sectors may be flavour of the season and experience high returns over the short term, they may not last forever. Long-term investors need to stay anchored to diversified mutual funds that have a long and strong track record.

What are SIP mutual funds? Are they better than normal mutual funds?

SIP - meaning Systematic Investment Plan, is not a type of mutual fund – so there’s no question of whether they are better than normal mutual funds! SIP is a method of investing in a mutual fund. There are two ways in which you can invest in a mutual fund: 1) Outright payment and 2) Automatic periodic investments. Outright payment is when you cut a cheque to the Mutual Fund Company or Distributor, whenever you want to invest. Automatic periodic investments mode (referred to as SIP), allows you to invest a fixed amount at constant intervals e.g. every month. Before staring a SIP you need to decide on – which fund scheme you want to invest in? Dividend or growth option? How much you want to invest? How often you prefer to invest (periodicity)? How long you want the SIP to go on? How you plan to make the periodic payments i.e. through cheque or ECS (electronic clearing/ direct debit from bank)? Hope this helps.

For SIP schemes, how is the holding period calculated for tax purposes? In other words, is the one-year period (for long-term capital gains tax to be applicable) calculated from the first SIP payment or the last payment or from the mid-point? Kindly clarify.

The system of first-in, first-out applies here. For tax purposes, the units that you sell first will be considered as the first units bought and holding period is calculated accordingly.

Q&A: Introduction to Investing in Stocks

2009-11-09T23:41:00.004+05:30

I am an Engineering graduate and recently took up my first job. I am new to investing in stocks but eager to make a beginning. Can you explain to me what exactly is a ‘stock’? Why we must invest in stocks? How can I start investing in stocks? - Reader

The most common misconception among new investors or people who are averse to investing in stocks is that stocks are simply pieces of paper to be traded (albeit electronically these days). Some even equate it to gambling. The truth is that although there are many speculators in the stock market hoping to make a quick buck, stock investment is different from speculation. In stock investing, trading is a means, not an end.

A stock is an ownership interest in a business. When a person or small group of people starts a business, how much of the business each founder owns is a function of how much money each invested. At this point, the company is considered “private”. Once the business reaches a certain size, the company may decide to "go public" through an IPO (Initial Public Offering) and sell a chunk of itself to the investing public. This is how a company gets listed in the stock exchange and stocks are created.

When you buy a stock, you become a fractional owner of the business. Over the long term, the value of that ownership stake will rise and fall according to the success of the underlying business. The better the business does, the more profits the company makes, and the more your ownership stake will be worth.

Once a company gets listed through an IPO, anyone can buy/sell the company’s stock and checkout the price of the stock in the stock market. The price of the stock at any point is nothing but the most recent price at which the stock changed hands from seller to buyer. In India, two prominent stock exchanges where companies get listed and their stocks traded are BSE (Bombay Stock Exchange) and NSE (National Stock Exchange). Both are electronic exchanges with computers doing the matching of buyer and seller. You can buy/sell a stock listed in any of these exchanges, only through stock broking companies who are registered members of the exchange.

So, the first thing you need to do to start investing in stocks is open an account with a stock broking firm. You can open a trading account with the broking arms of banks e.g. SBI capital securities, HDFC securities, ICICI securities or standalone stock broking firms such as IndiaInfoline or ShareKhan. The good news is that most stock broking firms provide you with online trading facility. This means you can buy/ sell at the click of a button and monitor your portfolio value on a minute-by-minute basis (although the latter is neither advisable nor necessary for being a successful investor). The second thing you need to do is open a demat account. These days, stocks are no longer available as pieces of paper - they are digital or in other words dematerialized. Your demat account is like an electronic locker where your digitized stocks are stored. You can choose to open your demat account with a bank or with your stock broking firm.

Reasons to invest in stocks

We all have financial goals in life: to pay for college for our children, to be able to retire by a reasonable age, to buy the things we want. Unfortunately, spending less than we earn is typically not enough for us to reach our goals. Thankfully there is help at hand – by merely investing our savings we can make it grow in value and generate returns. Stocks are just one of many possible ways to invest our hard-earned money. So why choose stocks instead of other options, such as fixed deposit, bonds or gold coins? This is because stocks are quite simply one of the best ways to make your investment work the hardest – they provide the highest potential returns over the long term. This is particularly important because even 1% extra return per annum over the long term can translate into windfall profit, thanks to the power of compounding.

On the downside, stocks tend to be the most volatile investments. Meaning their prices can vary wildly – both over short term and long term. There's also no guarantee you will actually realize any sort of positive return. So it’s important to know what you are doing and resist the temptation of buying a stock because you received a ‘hot tip’ (a sure-fire way to lose money).

The best part is - Investing in stocks is not rocket science and can be self-taught by reading good books and company annual reports. Books on Warren Buffett are a must read. Some other great investors whose books you can read are Benjamin Graham, Philip Fisher and Peter Lynch. As a beginner, I suggest you start with ‘Learn to Earn: A beginners guide to the Basics of Investing and Business’ by Peter Lynch. The only real characteristics shared among successful stock investors are basic math skills, a critical eye, patience, and discipline. Combine these with an understanding of how businesses satisfy customers, compete with one another, and make money in the process, and you have all the mental tools you need to get started. A primer on accounting would also help.

You may think all this sounds like a lot of effort, but it can bear many fruits – not only in the form of higher returns but also by helping you understand how the world works. Moreover, learning to invest is something that you can do at your own pace, as a hobby, for the rest of your life. After all investing is an art, not a science. Even the world’s greatest investors, continue to build on their knowledge and fine tune their skills by spending most of their time reading (and very little time on actually buying/selling).

Prepare for higher interest rate on your home loan

2009-10-08T12:02:00.003+05:30

Homebuyers must plan for future increase in EMI by using ‘margin-of-safety’ principle.

As residents in a high growth developing economy, we need to be prepared to face high interest rates from time to time – thanks to inflation!. The downside of high interest rates is that loans become more expensive. Now we all know who bears the major brunt of this. The homeowners of course – because of 3 reasons: 1) among individuals, home owners typically take the largest quantum of loan 2) among retail loans, home loans have maximum tenure – 20 years on average 3) most home loans in India are variable rate loans; even the banks that do offer fixed rate loans build-in a reset clause which allows interest rate on the loan to be increased in the event of a spike in prevailing rates.

If rise in interest rate is inevitable, the only way to deal with it is to prepare for it, before you purchase your home. Once you make the purchase decision, you will most probably lock yourself into a loan whose repayment is going to consume a good portion of your earning life.

The Margin of Safety Principle

A commonsense approach to prepare for future increase in your home loan interest rate is to evaluate the worst-case scenario, and then build a margin of safety. If you examine how interest rates have moved over the past decade, you will notice that the maximum level of home loan interest rates during this period was around 14% p.a.. So it may be reasonable to assume that the worst-case scenario is home loan rates climbing back to 14% p.a. during the next decade. If it does, you would have two options: make higher EMI payments or settle for extending the tenure of your loan. Although the bank earns more interest income if you choose the latter, for the customer the former option is any day better. After all, why would you want to pay interest charges to the bank for extra years? And who knows -may be you want to take an early retirement – in which case you would be unable to extend the loan tenure.

The margin of safety question is - can you pay the higher EMI charges if your home loan interest rate increases to 14% p.a. from the current level of 9% p.a.? To know if you can, the first thing you need to do is calculate what would be the EMI amount at 14% p.a. interest rate. Then you need to decide if you can afford this higher EMI level “today”. You may counter my stance as being unnecessarily extra cautious, by arguing that even if an increase in EMI were to occur, it is likely to happen only at some point in the future - when your salary would have increased and you may be able to accommodate the EMI increase if any. I disagree. These days, most couples become homeowners at around the time they have their first kid. So even if their salaries increase, family expenses are also likely to increase. It is better to be sure upfront (at the time of purchasing your home) if you can afford a higher EMI in the event of an upward revision in interest rate on your home loan. This would save you from the agony of trying to make both ends meet when the event occurs.
If you are not sure you can meet the higher EMI commitment corresponding to the worst case scenario of 14% p.a. interest rate level, it may be better for you to settle for a smaller, less expensive home at the time of purchase. This way you can start with a smaller loan amount and lower EMI, leaving sufficient cushion (margin of safety) for potential increase in EMI at any point in the future.

Sample calculation using Microsoft Excel

Following is an example that will help you calculate the maximum loan amount you can “afford” after considering a margin of safety, which will protect you in the event of increase in interest rate.

Let’s say the maximum EMI you can afford is Rs 30,000. At current market rate of 9% p.a. for variable rate loans, this EMI commitment can make you “eligible” for a 20-year loan of Rs 33.34 lacs. You can calculate your loan eligibility in Excel by using the formula PV(interest rate per month, loan period in months, monthly payment). For our example that would be PV(0.75%, 240, 30000) = 33.34 lacs.

But a loan for Rs 33.34 lacs would leave you with no margin of safety if the interest rates were to rise further. e.g. If the interest rate is reset to 14% p.a immediately after you take the loan (the worst case scenario), your EMI would increase to Rs 41,463 – an amount that you may not be able to afford. (Note: The later the interest rate reset happens during your loan period, the lesser would be your EMI increase. This is because principal outstanding keeps diminishing as your repay the loan.) You too can calculate the EMI pertaining to any interest rate, loan amount and repayment period by using the formula PMT(interest rate per month, remaining loan period in months, principal outstanding on your loan amount)

To ensure that your EMI never increases above your target amount (in our example that would be Rs 30,000) what you need to calculate is NOT how much loan you are “eligible”, but how much you can “afford”. You can compute your “affordable” loan amount by assuming a worst case interest rate of 14% p.a. (i.e. 1.16% per month) instead of the current market rate of interest of 9% p.a. The formula PV(1.16%, 240, 30000) gives you the loan amount that you can safely and comfortably “afford”- Rs 24.12 lacs. See how different it is from your “eligible” loan amount of Rs 33.34 lacs! That’s the effect of margin of safety!

Buying a home is a big financial commitment. It’s better to be safe and buy one you can really afford, instead of stretching yourself and facing the risk of Damocles’ sword.

Shyamscolumn goes to IFMR

2009-09-16T17:01:00.007+05:30

As part of the plan to extend this column beyond its presence on the web and in print (under FISCALLY FIT section of the Hindu Sunday Magazine) - last Monday (Sep 7, 2009) , I gave a lecture to MBA students at IFMR in Chennai. The agenda : How to Plan for Cyclicality in the Economy and Profit from it - as a Businessman, a Financial decision maker at a corporate or an Investor in the stock market.

A six-step approach to reduce cost of living

2009-09-16T16:29:00.001+05:30

Common sense technique coupled with out-of-the-box thinking can help slash your living expenses.

Over the last few weeks, the missus and I have been trying to ‘optimize’ (euphemism for cutting) our living expenses. The reason for this sudden frugality exercise? Well, for once, the missus has agreed that continuously striving for greater earnings might not be such a foolproof strategy for increasing our savings, especially given the vagaries of the economic environment. Moreover, lately there has been a feeling that our expenses increase with earnings, just like the old saying - “work expands to fill the time available”. With both our companies going to great lengths to save costs, we thought the timing could not be better to start our pet project on household cost saving. Here we share with you a simple but effective approach to cost saving that worked for our family.

Step 1: Annualize expenses

Our brains don’t seem to be programmed to take small numbers seriously. This is one of the reasons why we don’t feel the guilt when we indulge in items that cost less on a per unit basis. But it could be that all these seemingly harmless small indulgences, over an entire year, could turn out to be much more expensive than some of the larger one-off expenses. The only way to cheat our brain in this (and help it visualize better) is to annualize the typical expenses that we incur in a month, under various heads, by multiplying them by 12. Obviously before doing this, you need to note down what are your expenses in a typical month, item wise, including your loan EMIs.

Some people may disagree with including EMIs. Here I think it may be a good idea to make a few assumptions: 1) EMIs going towards investment plans will create assets worth atleast the value of investment that goes into it and are hence not an expense 2) loan EMIs that do not create an asset or create a depreciating asset (e.g. a car) are an expense (so you don’t splurge on such loans) 3) in the case of home EMI, only the interest portion is an expense (this way you know that it’s better to pay it off sooner rather than later). Please note that the above are mere thumb rules.

Once you annualize the expenses on your monthly list, add to it any one-off expenses that you typically incur in a year e.g. a vacation. Now you have the annualized and itemized list of expenditure to work on. The first thing that’s going to pop out is the total annual expenses that you incur. Many people faint at this stage, because they have never bothered to actually find out how much they spend in a year! But once you have an idea of this number, you can find out how much you can potentially save in the current scenario by comparing your expenses with your annual take-home income. While doing this comparison, just keep in mind that it may be a good idea to add an additional 10% to your expense list to 1) accommodate any unexpected expenses that you may incur during the course of a year 2) account for any underestimation in your other expenses.

When we did this exercise, the first thing that shocked us was how much we spend on eating outside. The missus and myself, both being foodies, usually eat out about three times a week, so much so that it has become the primary entertainment. Separately, a weekend lunch or dinner bill for two people may not seem exorbitant; but when annualized, the amount works out to an eye-popping number!

Step 2: Fix your percentage target for cost saving

This would depend on your comfort level about the gap between your income and total expenditure. We think a 10% reduction would be an ambitious target to begin with.

Step 3: Re-arrange the annual itemized list in descending order of expenditure

Just glancing at this list, can throw some surprises in terms of things that you thought were less expensive but have turned out to be higher and vice versa.

Step 4: Mark each item as discretionary/ non-discretionary

If need be you can prepare two separate lists for discretionary and non-discretionary items. What you need to keep in mind though: neither are all non-discretionary expenses (e.g. house rent) sacrosanct nor all discretionary expenses (e.g. a movie) a waste. What’s needed is out of the box thinking that questions both kinds of expenses, and creative ways to eliminate them or come up with cheaper substitutes. Few examples: 1) switching to a smaller car, car-pooling or using metro/ MRTS to reduce transport expenses 2) repaying a loan out of your annual bonus to reduce your EMI 3) Avoiding buy now- pay later schemes

Step 5: Do a Pareto (not Burrito) analysis before deciding where to cut

Calculate the percentage share of each expense with respect to the total expenditure. What you will notice is that few items contribute a lion’s share of the expenditure. In fact it is likely that your expenses will follow the 80/20 Pareto rule i.e. 80% of total expenditure comes from 20% of the items. Even if it doesn’t exactly fit into the Pareto rule, it would be a close substitute e.g. 70/30 or 60/40. What this reinforces is the need to prioritize expenses, when pursuing your goal to cut total expenditure. If you want big savings you need to attack the big-ticket items, although they may be the toughest to reduce. Of course, it doesn’t mean that you restrict your scope only to the larger expenses. The long tail of smaller expenses do provide an opportunity for quick wins albeit not meaty ones.

Step 6: Don’t forget to implement after you have done all the planning!

Happy saving.

Why it may be a good idea to apply for Oil India Limited (OIL) IPO

2009-08-28T00:00:00.009+05:30

Dear Readers,

Many of you who regularly follow my column would know that I generally don’t consider IPOs to be attractive investments. Then why this sudden volte-face you may ask? Well…usually IPOs come with baggage: either a high price, or low quality or both. Recently, I was listening to a speech (on YouTube) by Charlie Munger (the not so popular side kick of the billionaire investor Warren Buffett) to students at the University of Southern California (USC). In the course of his speech he mentioned about a particular aspect of human nature that he felt was a big danger in life: intense ideology and the resulting lack of open mindedness to examine disconfirming evidence. So, while I may still be skeptical about IPOs, what I have uncovered is disconfirming evidence - a rare worthy IPO (issue opening Sep 7th, 2009)

OIL is a company that’s been around for 50 years. It is the second largest public sector oil and gas producer after ONGC (but only 10% the size of ONGC). Over the last nine years the company has generated an average return on capital in excess of 20%. The company has almost no debt (loans). It has steadily paid increasing dividends year on year to its investor – the Government of India (till date). Going by the long-term track record, the company has demonstrated that it is doing very well financially.

Of course there is a huge macro risk – which is the price of oil. If oil price crashes and stays below $30, it may adversely impact profitability of oil production companies. Currently oil price is around $70. There are numerous highly intelligent people making a living out of predicting the price of oil. But even those who get it right the first time, trip when they try their luck again (remember the famous Indian research analyst who first correctly predicted oil will touch $100, but later upgraded the price target to $200, only to see it fall even below his first prediction). Although there are many alternative fuels under development, many of these are prohibitively expensive or inaccessible. They are unlikely to impact the demand for oil – atleast not over the next decade. Infact, oil consumption will continue to increase, as it has done over the last many decades – but may be slower. That’s on the demand side. On the supply side, everyone believes the world is running out of oil– so as long as this fundamental belief is not disproved, the price of oil can be reasonably expected to stay at current levels or move up over the next decade. The same argument can be extended for gas.

The second macro risk is the subsidy regime of our Government, which currently mandates PSU oil-producing companies in India to share the burden of selling fuel at below market price. Despite this, PSU oil and gas production companies in India, including OIL, have managed to maintain their high profitability in the past. So I think we can assume that as long as the Communists don’t come to power, oil-manufacturing companies can maintain their profitability.

Now, let’s get to the pricing of fresh shares in OIL that are being offered in the IPO. Firstly, only a small portion of fresh stock is going to be issued in the IPO - 11% of post issue total shares to be precise (I am not counting the portion of existing shares (10%) that would be sold by Government of India to the Oil marketing companies – namely IOC, HPCL, BPCL). At the higher end of the price band (Rs 1050 per share) at which fresh shares in the company are being offered, the post issue Enterprise Value of the company (approx. 25,000 crores) will be around 2.1 times the total capital in the company’s balance sheet i.e 2.1 times the ‘book value’ of total assets (post issue).

Book value of assets refers to what you would get, if you were to strip the company into parts and sell them chunk-by-chunk. In other words, ‘1 time book-value of assets’, is the bare minimum that the company would be worth, if it were to shut down tomorrow. We all know this is not going to happen. I think this company is going to continue to exist for many years to come and most likely continue to earn a return of 20% + on the capital that it uses. FYI this is more than twice the passive return generated by money in a bank FD. For this superior return generating potential, the IPO price is valuing the company at 110% premium to the value of assets in the company. This, according to me, is at a discount to the true fair value of the company. In my opinion, this IPO provides an opportune time to get into a strong company and compound your wealth for many years to come. May be that’s a reason why the Government is diluting only a small portion of its stake at this point.

Does this mean post listing the stock price of OIL will never come down below its issue price? No.

Would there be an opportunity, in the near future, to buy this stock cheaper? May be.

Is there risk of ‘permanent’ loss of capital if you invest at current price being offered in IPO? No.

What is the long-term average return that you can expect if you invest at the IPO price? 15%-20% p.a.

Please note: the standard disclaimer applicable to any investment advice applies here too. And…please don’t go bonkers and invest 100% of your net-worth in this. For the overzealous types, here’s my adaptation of Mr. Narayana Murthy’s famous saying: In God we trust…in stocks we better diversify.

Regards,
Shyam Pattabi www.shyamscolumn.com

Smart marketers and naive consumers

2009-08-17T21:59:00.004+05:30

Understanding the strategies adopted by FMCG firms can help save a bunch of money in your monthly bills.

FMCG (Fast moving consumer goods) companies have managed to become one of the most successful firms on this planet, in terms of sales growth and profitability. This is great news for the shareholders but not so sanguine for consumers. Although the products sold by FMCG firms are fairly mundane - such as soaps, toothpaste, soda etc.., they add up to significant amount of annual consumer spend and are highly profitable to the firms that sell them. Some reasons for the enormous success of FMCG sector compared to other industries are 1) The products have low price per unit - so consumers don’t feel the pinch 2) Their smart marketing strategies make the consumers feel that the product is indispensable and encourages higher consumption even when it is absolutely unnecessary 3) Consumers believe that the products offer so much more in “features” than what they pay 4) The product features are insignificant in terms of cost-to-manufacture and may not even be “real” for that matter, enabling a high profit margin for the firm.

Low on requirement. High on consumption.

A great example of an unnecessary but hot selling product is ‘cola’. There are only two cola companies and they keep getting bigger. I can’t think of any reason why soda should cost that much…but there is a tacit understanding between the players to not tamper with the price (thanks to the duopoly). Combine this with ubiquitous celebrity ridden advertising (where men jump out of skyscrapers to grab a bottle) and every time you feel thirsty, you want to have cola instead of water – to the extent of addiction. This is despite the fact that the latter would actually quench your thirst better while the former only leaves you de-hydrated. Ever calculated how much money you spend on cola in a year?

Let’s take another example - toothpaste. The most basic white toothpaste (with no stripes, or any other bells and whistles) would suffice. Many scientific studies have proven that it’s the manner of brushing that matters more than the kind of toothpaste you use. But we have all kinds of fancy pastes in the market – some claim to have seductive power, some even offer the moon on your teeth! And, we buy the more expensive varieties without realizing that they are not necessary and may not be of any more help than their cheaper cousins.

Ask any good dentist and he/she would recommend that you just use a pea-sized portion of the paste when you brush your teeth. Yet, toothpaste ads display the entire length of the bristles in the toothbrush being filled with paste (as if the guy’s getting ready to brush a crocodile). I bet most people blindly follow such pictorial depictions and fill their brush with paste (thinking that’s the right thing to do), without even realizing that it’s not required! One individual using a little extra toothpaste may not be a big deal to a large corporation that sells paste. But imagine, what if the entire world is using twice or thrice the amount of paste that it needs. That’s 100% to 200% more revenues for the firms that sell them.

Strategic packaging

You would have never thought that the size of the nozzle could be an important issue in packaging consumer products. When you buy toothpaste, do you think it is better to go for smaller tubes or bigger tubes? Obviously, you would think the large tube works out cheaper. But the reality is a bit different. Bigger tubes have nozzles with bigger diameters. So, in effect you use more paste per day!

The nozzle issue doesn’t end with toothpastes. It seems to have penetrated hand washes too. Recently during a Sunday trip to the supermarket with the missus, overcome by the desire to make my presence felt, I did some comparison-shopping to identify the cheapest liquid hand wash available in the store. But soon I realized it was not so cheap afterall. The pump and the nozzle system were just overenthusiastic. Even a small press and it would dispense excessive amounts of the liquid. On closer examination, the nozzle was too big and the pump was too broad, and this made it multiply any pressure exerted on it. Within a few days the dispenser was empty and I had to get a refill (which, as funny as it may seem, filled only three-fourths of the capacity of the original container…what a mastermind). Suddenly I felt – the good old soap bars are so much better and cheaper than the fancy liquid hand washes.

Beauty products

It is common in our country (all over the world?) for women to lay extra emphasis on natural ingredients when it comes to beauty products. As sad as it may sound, the reality is that it is not possible to make an entire bar of soap out of 100% natural ingredients. Most of the stuff in a soap, shampoo or skin cream is made from synthetic chemicals – including the “natural smelling” fragrance that produces better aroma than the real thing! Check the ingredients in your skin product - you will either notice an insignificant portion of the key ingredient that captivated you (e.g. sandal, honey etc..) or find no trace of it! Of course, all this has no bearing on the marketing of the product – which revolves around a celebrity wallowing in a tub filled with gallons of milk, hundreds of almonds, kilos of saffron etc. (I sometimes wonder is this really what women want?). The best part is when the ad goes on to show the entire contents of the tub get condensed into a bar of soap!

Can we ever outsmart the intelligent marketing behind fast-moving consumer goods? I think it’s definitely worth a try.

A story for every investor…

2009-08-02T15:26:00.003+05:30

Here is an interesting article, which I feel every stock investor needs to read and probably keep it framed on the wall. It’s a fine example of one man who lost almost everything, but kept walking due to perseverance. It’s also a story about what not to do while investing....

Published in Economic Times, Aug 2, 2009 (Written by Harsimran Singh)

“When my father died last month, I discovered he used to support four poor kids, with his meagre government pension,” a mellowed Lemon Tree Hotels owner Patu Keswani, recounts, sitting in his plush Okhla office, in South Delhi.

The IIT-IIM alumnus, was almost broke in 2001, when he lost all his life’s savings (Rs 97 lakhs out of Rs 1 crore) in the stock market. The 50-year old CMD, who now owns 11 hotels with a revenue of over Rs 103 crore, wants to adopt 5,000 poor children in Delhi and 3 MCD schools and venture into corporate social responsiblity aggressively.

“It’s not how much you donate, but how much it can make others happy, which counts,” says a calm Mr Keswani. The man who used to run the entire Taj Hotel chain as the Chief Operating Officer, till 2001, is a changed man now.

“I used to be arrogant earlier. But life has made me realise that arrogance and haughtiness, is a mark of low self confidence,” he says. “Politeness makes good business sense, especially in an industry like ours,” he adds, puffing out smoke rings from a cigar and sipping his favourite ginger tea, even as Pavan Ahluwalia, son of Planning Commission chairman Montek Singh Ahluwalia, looks on.

While I listen to Mr Keswani’s trysts with destiny, the Stanford educated Pavan listens intently, as he waits for a business meeting with him.

“Let me show you something interesting,” Mr Keswani says, excited like a child. He pulls out his desk drawer, and from a maroon velvet coated box, out he flings out a Cartier watch. “It was 1998. One evening we three friends were sitting in the Taj President, Mumbai. All of us had decided to retire at 39 years. A sum of Rs 5 crore, we all agreed, was good enough to retire. But all I had was Rs one crore in savings, which I decided to invest in stock market, to see if I can make more,” he says.

Under the advice of Mumbai based XYZ Securities (we decided to keep the name confidential), he invested all his money. But after a year, one crore was wiped out, reduced to just Rs 3 lakhs. He was gifted the Cartier watch by the owner of the brokerage for being a ‘valuable customer’. “Suddenly after a few months, the watch stopped working. I showed it to the makers and they told me it was a fake. It was not losing Rs 97 lakhs, but the fake Cartier watch, which hurt me more.”

But Mr Keswani has since learnt to take things in his stride. He has also started to believe in coincidences. Once, roaming on the Candolim beach in Goa, he was awestruck by a dilapidated resort hotel. A few minutes later, he got a call from a friend who told him that a property was for sale on the same beach. It was the same hotel. The next day, Mr Keswani bought it for Rs 3.5 crore, by paying Rs 10 lakh in advance. The next month, he sold it for Rs 5 crore, making a cool Rs 1.5 crore profit and buying more land.

He now has in his kitty about 22 plots. The Goa hotel buy, reminds him of his IIT days, when he bought his first motorcycle for Rs 2400. “Being a government servant, I could not ask my father for a bike those days. So, I paid Rs 200 for the bike in advance. The rest (Rs 2200), I arranged over the next 30 days, by winning bridge games at Gymkhana Club, near Prime Minister’s House, in Lutyens Delhi.” Interesingly, the B.Tech. in Electrical Engineering from IIT-Delhi, thinks that all IITians are a ‘bunch of sad guys.’

“I scored 95% in mathematics in my first semester in IIT, but got a C-grade. The only way I could manage an ‘A’ was by getting 100%! So I decided to aim for a B grade. I enjoyed all four years at IIT, playing snooker, bridge and biking all over,” he adds, as he glances at the cute animal cartoons hanging on the wall.

His 11-year old daughter, acts as part time interior designer for Papa’s office, as she keeps on churning out new drawings for his office. She also acts as a business advisor as Papa’s new Economy Hotel Chain’s name—Red Fox has been suggested by her. The first two Red Fox Hotels (in Jaipur and East Delhi with 300 rooms), will commence operations by end 2009. Red Fox Hotels is also developing three more hotels aggregating 550 rooms in Hyderabad, Delhi and Gurgaon which will be operational by 2012.

Talk about competition, and Mr Keswani blasts the business strategies of most hotel chains in India. “By 2012, Lemon Tree Hotels will own and operate 20 hotels aggregating over 3,000 rooms with 4000 employees across 16 major Indian cities. We want to own over 2% of all hotel room inventory in India.”

But talk about charity, and the history enthusiast, says he wants to open a social trust now, even as he recounts conversations about life over the past two years with his late father, as he battled with liver cancer. “I want to open a trust,” he says exemplifying Alexander the Great. “Alexander had told his grave men not to embalm his hands, and keep them open to signify that he took nothing. I plan to do something similar by entrusting wealth to a social trust, when I’m gone,” he adds.

- The End -

Few Lessons for Investors (in no particular order and by no means comprehensive) – by yours truly

1) How to invest in stocks? Just like how porcupines mate…”very carefully”.

2) Two rules for stock investing (Warren Buffett) #1 Don’t lose money #2 Don’t forget rule no. 1.

3) Never invest lump sums in equities in one go…you may also lose it in one go.

4) If you are new to stock investing…invest in small lots for the first few years

5) Do not put all your eggs in one basket…diversify between stocks.

6) A ‘balanced-diet’ is not only good for physical health but also for financial health…invest some money directly in stocks, some in mutual funds, some in bonds, some in FDs, some in real estate.

7) Invest in stocks of “good” companies (my past articles offer some insight on this aspect). "It’s only when the tide goes out, you see who’s been swimming naked" – Warren Buffett.

8) Do not invest in companies that carry high level of debt (loans). Zero debt companies are the safest. Some sectors are inherently risky due to high levels of debt – such as real estate, infrastructure and banks. Be extremely careful while investing in these sectors.

9) Invest in companies that have long track record…longer the better.

10) Don’t blindly take advice or “recommendations” from stock-brokers.

11) Don’t invest in stocks for the wrong reasons…e.g. in the height of the bubble for fear of being left out.

12) Don’t expect more than 15% returns p.a on stocks. The lower your expectations, the safer the stocks that you will invest in.

13) People do become overnight millionaires, just that they lose such millions soon enough.

14) Don’t invest in a hurry.

15) Stock investing is for the long term (5 –10 years) by its very nature…desire for quick short term returns can lead to loss of principal.

16) Systematic investing in stocks (directly or through funds) helps ‘beat’ inflation and meet long term goals – such as child’s higher education etc.., but as you near the goal – you need to start withdrawing portions of the money and invest in fixed return instruments to ensure capital protection.

17) If you need money for some event within the next 3 years, it’s better to take that money out of the stock market and invest in fixed return instruments.

18) For novice investors, Mutual funds (not NFOs, but funds that have been around for atleast 5 years) or Index funds (e.g. NIFTY BEES) offer a safe alternative.

19) Watch the P/E (price to earnings) ratio of the Index before you invest (> 24 or 25 is danger) (again…more on this in my previous articles)

20) Stocks quoting at extremely high P/E ratios carry similar risk…because you are paying for future earnings which may or may not materialize.

21) Acquire and constantly update the knowledge required to make and monitor investments.

22) If you are investing directly in stocks…do some homework – check out their products, talk to customers, employees to get a better sense of the company.

23) If you don’t understand what the company does…it’s better to stay away from the stock.

24) If you are too lazy, not interested or don’t find the time to monitor your investments - FDs, post office schemes, PPF and other fixed return avenues are better options, although they may not offer much in terms of returns after you subtract the effect of inflation.

25) If you plan to start investing in stocks for the first time, it’s safer to do so after a big crash, because the worst may be behind you.

Shyamscolumn.com goes offline…

2009-07-23T23:57:00.005+05:30

Last Saturday (18th July), www.shyamscolumn.com went offline with an invitation-only lecture - delivered by yours truly. The event was organized by IGP Group ( http://www.igp-group.com/ ) for its senior management team. The theme of the talk was “Becoming Cash Rich & Debt Free: The essence of corporate success and longevity in a cyclical environment”

Since the programme turned out to be significantly better than my expectations (NOTE: this is purely my opinion and may differ from the audience’s), I have resolved to give more such lectures in the near future (subject to time constraints).

Educational Institutions, Companies or any other Organizations willing to take the risk of listening to me, in return for some humour–filled Gyan, are welcome to be my host.

Interested?? Drop me an email at shyamscolumn@gmail.com

Mutual fund dividends are not free lunch!

2009-07-23T23:35:00.009+05:30

Published in The Hindu - Sunday Magazine on Aug 02, 2009

A bumper dividend announcement by a mutual fund scheme does not per-se merit investment.

The two popular options when it comes to mutual fund investments are: dividend and growth. As you may all know - mutual funds simply use your money to buy stocks, bonds or other investments. The value of investments and cash surplus held in a mutual fund scheme is reflected in its NAV. Time to time fund schemes get dividends or interest payments from these investments. They also make profits on selling some of these investments. Over time, these provide cash inflow for the mutual fund that it can either choose to re-invest by making fresh investments (growth option) or payout as dividend to unit holders (dividend option).

An Illustrative

Now lets take a look at the impact of a dividend or its absence, on the price - meaning NAV (net asset value) of the fund scheme. Lets say, six months back, a new Equity mutual fund scheme was launched and collected money from investors at Rs 10 NAV under two options – dividend & growth. Today, the NAV of both the growth option & dividend option is Rs 15. Due to exceptional performance, the dividend variant of the scheme has decided to book some profits in its investments and share the same with its unit holders. So it’s announced a 25% dividend. i.e. Rs 2.5 per unit.

Now Mr. Ramesh, a mutual fund investor, gets a call from a fund distributor who updates him on this “exciting” news on the very last day for dividend eligibility. Mr. Ramesh, tempted by the idea of reaping quick gains, invests in the dividend option of the scheme paying Rs 15 NAV – hoping he would earn Rs 2.5/ Rs 15 i.e 16% returns. Is he right in expecting this? Unfortunately, no. The next day (the day after the record date), assuming the market remains at the exact same level and all share prices remain unchanged, Mr. Ramesh would be shocked to see the NAV of his investment drop to Rs 12.5. Why?

This is because a dividend from a mutual fund is nothing but a return of capital held by the fund scheme. The Rs 15 NAV of the scheme with the dividend option already included the distributable cash of Rs 2.5, on distribution of which, as logic would suggest, the NAV reduced by an equal amount. There is no free lunch really! The NAV of the scheme with the growth option would remain at Rs 15 – because the scheme didn’t distribute a dividend. Mr. Ramesh is no better off choosing the dividend option instead of the growth option. And, his purchase decision triggered purely by the lure of quick returns through the dividend is a misinformed one.

Every time a fund scheme announces a dividend, the same scenario will repeat. i.e. the NAV of the scheme will drop by an amount equal to the dividend amount. Within the same scheme, the NAV of the growth option will always be higher than that of the dividend option because - money is going back into the scheme and not given to investors. For example, if you were to look at the NAV of HDFC Top 200 equity scheme as on Jul 17, 2009 - it is Rs 148.4 for the growth option and Rs 38.3 for the dividend option. The reason for the difference in NAV between these two identically managed plans is that one keeps stripping money and dispatching it to investors while the other just re-invests any gains (income). It is this re-investment that has accumulated and appreciated over time, resulting in a much higher NAV today – a substantial capital gain.

So, is there any difference at all to the investor whether he invests in the growth option or dividend option within the same mutual fund scheme? Yes, their tax treatment.

Tax treatment of capital gains and dividend

The enclosed table illustrates the tax implications of dividends compared to capital gains. If you are going to hold your mutual fund units for over a year from the date of investing, capital gains have equal if not lesser tax outgo compared to dividends. On the other hand if your holding period is less than a year, then dividends attract less tax than capital gains.

For long-term investors

Taking a long-term perspective, investors who need income can choose the dividend option – although this option neither guarantees the amount of dividend nor the frequency. Past dividends are in no way an indicator of future dividends, but a track record of consistency is favourable. The dividend amount should not be the sole deciding factor while investing, because technically a fund can declare high dividends by merely selling its assets – irrespective of whether it has made a profit or loss! So dividends need to be evaluated in conjunction with the total returns that the fund has been able to generate.

Investors who only need long-term capital gain (wealth appreciation preferred over income) can choose the growth option. Such investors can still pay themselves a dividend when they want liquidity or when they feel the market is overvalued, by simply selling the requisite number of units!

The Myth about NFOs

2009-07-07T14:14:00.003+05:30

Published in The Hindu - Sunday Magazine on Jul 12, 2009

Investors have a misconception that New Fund Offers are cheaper than existing fund schemes.

Over the last couple of months, there has been a surge in investor interest for mutual funds. And as expected, UFOs, er..NFOs are back. As on Jun 2009, the money managed by mutual funds in the country was around Rs 6,70,000 crores across thousands of schemes managed by forty-odd fund houses. This is expected to triple by 2015! (Source: KPMG). With so much money going into mutual funds – one would expect the average retail investor in a mutual fund to possess atleast the basic knowledge about mutual funds. Ah! Me with my stubborn optimism…I couldn’t be more wrong. The truth (however hard to grapple it may be) is that the popularity of an asset class (mutual fund) does not imply that people understand it! So, for most people, the reason for investing in a mutual fund is as simple as - “The stock market is rising and I want to make money, yaar”

In the eagerness to not be left out in the bull-run (wonder why even as adults we harbor nightmares about being left out of the game?) many investors get caught in the wrong fund or invest for the wrong reason. The direct consequence of this ignorance is the hype about NFOs. It’s hard to believe that the next NFO is going to achieve something better than what thousands of existing schemes cannot.

The common myth about Equity mutual fund NFO is the perception that an NFO at Rs10 is cheaper than an existing scheme with a higher NAV(net asset value). This school of thought believes that lower the NAV better the bargain.

At the time of launch, all mutual fund schemes, issue units at face value of Rs 10. This is just an arbitrary number, but it is the standard practice. Here’s a hypothetical example. Let’s say a popular NFO named Tiger, is offering units at Rs 10 per unit. A competitor’s NFO named Pussy Cat is offering units at Rs 5 per unit. Does this mean Pussy Cat is cheaper? Of course not. Remember, an NFO is a mutual fund scheme that is being launched for the first time and is collecting money from investors so that it can make its first investment. The bottom-line - the money collected by the NFO is going to be used to buy stocks worth the amount you paid…not a penny more. You pay Rs 10 for a unit of Tiger and you will hold assets worth Rs 10 per unit; you pay Rs 5 for Pussy Cat and you will hold assets worth Rs 5 per unit (Note: for the sake of brevity, I am ignoring upfront fees that will be deducted). So there’s no bargain really and the face value of a unit is equal to the NAV i.e. net asset value per unit (Rs 10 for Tiger and Rs 5 for Pussy Cat respectively). The returns that I will get are going to depend on what stocks the two funds buy with the money and how these stocks perform – not on whether I paid Rs 5 or Rs 10 per unit.

Let’s fast-forward three years from now. The stock market witnessed a significant increase during the period and now one unit of Tiger is worth Rs 15 (NAV) and one unit of Pussy Cat is worth Rs 7.5 (NAV). Am I right to say that Tiger has performed better, since its NAV increased by Rs 5 while Pussy Cat’s NAV has increased only by Rs 2.5. No! I need to compute their respective returns in percentage terms, which works out to the same approx. 15% per annum appreciation - for both Tiger and Pussy Cat. Had I invested Rs 1000 in each of the schemes, my investments after three years, would each be worth Rs 1500.

At this point in future, let’s say you have a chance to invest additional Rs 1000. Call it great timing, there is a NFO in the market called Jaguar, which is offering units for a bargain price of Rs 5. Now I have three options. Buy units in already existing schemes 1) Tiger at Rs 15 per unit 2) Pussy Cat at Rs 7.5 per unit. Or as a third option, invest in the Jaguar NFO at Rs 5 per unit. Which scheme should I invest in?

The right answer – the decision should be based on appreciation (returns) potential post investment and not on cheapness (price or NAV) of a mutual fund scheme. Irrespective of varying NAV levels of the three schemes, a similar performance level of 15% per annum across the schemes would increase your wealth by the same amount. The NFO Jaguar that claimed to be a bargain is no bargain actually and that’s the truth that is rarely understood!!

Sadly due to the media blitz of NFOs (claiming their cheap availability at “just” Rs 10 NAV!), the fact that what matters is the percentage return on invested funds and not the NAV level at time of investing, is overlooked. NFOs are in no way cheaper than existing schemes. The only truth is - they are more risky than existing schemes. The longer a fund scheme has been alive and the longer its track-record of returns, the safer it is to invest in. Even then, the past performance of a scheme is not an indicator of future performance. But, at least having long-term track record on your side is better than having no track record whatsoever (which is the case of an NFO)!

Know your financial advisor’s incentives

2009-06-25T19:30:00.005+05:30

Published in The Hindu - Sunday Magazine on Jun 28, 2009

Financial services companies have mandatory “Know your customer (KYC)” guideline; It’s time investors have a “Know your Financial Advisor (KYFA)” guideline.

Last weekend a doctor couple met me for advice on planning their finance and investments. After hearing about the mess that they were in, I could not resist but ask why they had not sought professional financial advice earlier. The reply threw me back – apparently every single investment decision was made only under the guidance of their financial advisor – who surprisingly never charges a penny. What? Who is this “brilliant” Good Samaritan? – was my retort (forgive my callous sarcasm). It turns out their “advisor” was an “agent” – meaning his primary source of income is the commission that he makes from the investment products he sells. So what? You may ask. Well…I am sure there are well meaning agents out there but the issue is – “independence”.

The fundamental conflict of interest

To help my clients understand this better I posed them with an analogical question- would you go to a doctor who works pro-bono but gets paid only from the medicines that he gives you? “Of course not” was their reply. “Why?” I asked. “Because then the doctor would not only be tempted to prescribe more medicines than required but also resort to prescribing the more expensive ones”. Fine, what if the doctor gets a percentage cut from the pharma company, on the medicines he prescribes? I probed further. “Hmm…” they said – “The pharma companies would love to implement this, because doctors would turn into direct selling agents and they can do away with medical reps.”.

Unfortunately something that is so obviously a conflict of interest in the medical context is most easily overlooked when it comes to the financial services industry. Infact I think I can safely (and sadly) state that conflict of interest has become industry practice in financial services. We don’t seem to hesitate even once before taking “advice” from agents, who get commissions from the very companies whose products you choose! Be it your stockbroker, real-estate broker or the insurance advisor – all of them are agents who earn commissions based on what product you invest in, how much you invest, how often you buy and in the case of stockbrokers - also based on how often you sell. Why, even the investment banker who advices on Mergers & Acqusitions is an agent who gets paid a “success fee” that is proportional to the size of the transaction – only if the client is successful in buying or selling. It's in their interest to do whatever it takes for the deal to go through, because that’s when they get paid big bucks; the bigger the acquisition the better. Strangely despite this incentive problem even large companies look to investment bankers for “advice” on M&A. Do you think they are going to say no to billion dollar acquisitions like Tata-Corus or Hindalco-Novelis simply because the transactions are inherently risky and involve taking on a lot of debt that may put the entire company at risk of collapse? It's hard to say but I don't think they would! In fact they are likely to convince the company to go ahead with the acquisition so that they can earn their big fee. Because their incentive doesn’t encourage them to be concerned. The same predicament exists for your agent, when he plays the role of a financial advisor.

Stocks

You may be ogling over how often your stockbroker (online or offline) provides you with free “research” based advice (“recommendations” or “calls” in industry parlance) - some broking firms even tout the frequency and the quantity of such recommendations as their USP. But not many people realize that the monthly, weekly, hourly, (minute by minute?) buy/sell recommendation is aimed to fulfill the broker’s requirement of generating commission income, which incidentally is earned only when you execute a trade (buy/sell). Remember investment “recommendations” from a stock broking firm is not some kind of “value added” service or advice; it’s merely a marketing tool to induce you to trade.

Mutual funds and other investment products

The new proposal by SEBI - mandating mutual funds to remove entry loads, which is used by the funds to pay the distributing agents, is a step in the right direction. If the revised proposal is implemented, investors need to directly pay a mutually agreed commission to their agent - which is a good thing because at least it makes the process more transparent. But still a couple of larger issues remain un-addressed. First is the case of ULIPs, which despite becoming an extremely popular investment class of-late, have very little regulation in terms of fee structure to agents (may be that’s why they are popular in the first place!). Second, there are no signs of finding a solution to the more fundamental problem of agents turning into financial advisors and hard selling investments, purely for their own benefit (“incentive”).

Way forward

My opinion - as long as financial advisors are agents who earn their fee only when an investment product is sold, their incentives increase the risk of mis-selling by supplanting investors’ need. The only way to protect yourself from this is to know exactly “how” and “how much” your financial advisor will get paid (what’s in it for them?) - before you make your investment decision.

Are you a victim of the trend?

2009-06-05T22:51:00.005+05:30

Published in The Hindu - Sunday Magazine on Jun 14, 2009

When it comes to stock investing, misguided reasoning of trends prevents investors from buying cheap.

After the stock market witnessed a historic bounce post elections, the number of emails that I receive with request for investment advice has doubled. What puzzles me is why people who want to invest in the market wait for the prices to go up before stepping in. It’s like waiting for the discount sale to end so that you can start shopping! Shouldn’t the inverse be true? If I am a net buyer of stocks until I near my retirement (I expect most people are), I would be glad if the prices stay down so that I can continue to buy cheap. In fact I would like all the appreciation to happen only after I reach the stage in life when I plan to stop investing and begin to encash my savings.

One reason people are eager to watch their stock prices constantly rise is because they are unable to bear their neighbours’ boasting about property appreciation. But there is a key difference between the two classes of investment – stocks and real estate. Most people buy property by taking a hefty loan- sometimes up to 85% of the value of the property. The property investment itself happens on a lumpsum basis on day zero, although repaying the loan would continue for the next twenty years. Since the entire investment is done upfront, it pays for the appreciation to kick-in with immediate effect. On the contrary, when it comes to stocks, people don’t generally take a loan and make their total investment upfront. Instead they invest periodically over time to reap a lumpsum benefit after many years. In the event of a constant upward trend in stock prices, while you may earn high total returns on your early investments, the returns on your later investments would shrink. In fact the higher up on the upward trend line you invest, the lower your total returns.

But why do most people hesitate when they get an opportunity to buy when the market trend is down? Apparently, the culprit is “our brain”. Our brains are pattern-seeking organs and extrapolate every trend that they spot. When we see the market falling, we expect it to fall forever. Similarly when it is rising, we expect it to rise forever. And funnily the age of the trend makes this faulty reasoning even more pronounced and convincing. For example, if the market has continued to fall for many months, then we think it will definitely fall even further. Likewise our confidence gains strength as the market rises and eventually reaches its peak when the market is at its peak. As a result, most people get caught in “perfectly bad timing” by waiting for prices to fall significantly before they sell or rise significantly before they decide to buy.

Another figment of our brain is “loss aversion”. Our hatred to experience a loss is more than our love for profits. So we are not even willing to suffer a short term notional loss by buying on the downward trend, although doing so would give an opportunity to reduce our average purchase price and increase our chance of “actual” profit when the trend reverses. On the other hand, we are perfectly okay in buying on the upward trend; despite the fact that this increases our average purchase price and exposes us to higher risk of “actual” loss should the trend turn direction (something that trends always do sooner or later).

I have seen many people get jittery when their stock does not increase the next minute after they purchase it. Let it fall a few points below the purchase price and they are petrified. Some quickly sell when the price breaches random stop losses while others just stay invested, cursing themselves. The latter group would either sell at rock bottom when they finally give up hope or wait for the trend to recover and reach a level close to the purchase price so that they can then sell for a minimal or zero loss. But isn’t the idea of investing to make a profit?

Here’s one more common behavioral quirk. God forbid, if the stock rises for two consecutive weeks after the purchase, people start thinking that they have cracked the code to the roulette table or something. What could be worse is that some of them start believing that they have acquired a special “skill” to invest, when the fact of the matter is “it’s not them”, “it’s the trend”. Misguided by the trend, instead of cashing out with the money, they either make new bets or increase the size of existing bets – at higher prices. “If I made 50% in one month, imagine how much I can make in one year” would be the governing logic. As you know, this is no logic but just rubbish - because most trends don’t last forever; even the one’s that do, go through many crests and troughs in-between.

An oath for the amnesiac investor

2009-05-25T19:16:00.000+05:30

Published in The Hindu - Sunday Magazine on May 31, 2009

With the stock-market surge having erased all memories of the recent crash, the best prescription for amnesiac investors is an oath to not make the ‘same’ mistakes this time.

It’s hardly been a few months since the market hit rock bottom, when papa bear - Shankar Sharma cooed on CNBC that he would not be surprised if the Sensex plunged to 5000. But now that the UPA is back – Voila! Our economy is going to instantly recover with the tap of a magic wand. Just that instead of a fairy godmother, we are counting on ‘politicians’ this time.

The market crash of 2008 has already faded into a distant haze and so have the lessons learnt (if at all there were any). Chartists are rife with predictions about Sensex hitting 18000 this year and our own Shankar Sharma now says he would not be surprised if the market rises by 40% in the near term.

If you ask me what the economy or the sensex will do this year – the answer would be ‘I don’t have a clue’. What I do know are 1) Economies don’t improve overnight; they grow over the long term but in cycles 2) Over time, a wise investor can clock-in at least twice the annual returns from Bank FD by investing in stocks, provided he doesn’t forget the ‘cardinal’ rules.

Here is an oath for over-exuberant investors who have already forgotten the pain caused by mistakes of the past:

I will reduce my exposure to equities when the numbers point to a bubble
It is dangerous to remain fully invested in an expensive market. One can easily verify how expensive the market is by checking the P/E (price to earnings ratio) of the Index at: http://www.nseindia.com/content/indices/ind_pepbyield.htm

History has shown that whenever the P/E of the Index rises over 22, we are in for trouble. So resist buying at such levels and try to reduce your overall holding in equities to be on the safe side.

I will not be seduced by trends
It’s tempting for our brains to observe a high growth rate and then simply extrapolate this trend into the future, like what we did with real estate stocks. This has proved to be fatal, time and again. A fine example is the stock price of Infosys in year 2000, when it was trading at a price equivalent to 350 times the annual earnings per share, with high hopes that the company will continue to grow its earnings at nearly 100% p.a. But we all know what happened, earnings did grow but not as high as expectations and today this excellent company is available at pretty much the same price as it was 9 years back.

I will not salivate over companies making mega-acquisitions
Acquisitions take many years to work and many of them fail. Buying a stock just because the company has made an acquisition is foolish. While synergies are easy to quantify on paper, realizing them is an entirely different ball game. What one must stay away from are companies acquiring firms larger than themselves, by paying ‘cash’ and that too borrowed from the bank! That’s a potential triple whammy.

I will depend on ‘margin of safety’ to protect myself
The case for investment in a stock is based on the future performance of the company. But as we have seen it’s hard to predict future performance. So the ways to hedge your bet are: A) never invest 100% of your cash reserve in stocks B) buy stocks at minimum 30% discount to the conservatively estimated intrinsic value.

I will not borrow to invest in stocks or invest in companies that have too much borrowing
Investors and promoters who borrowed too much are either forced to liquidate their assets at dirt-cheap prices or stuck with loans worth much more than the value of underlying investments. Don’t borrow money to buy stocks and avoid investing in highly indebted companies (companies with > 25% debt/ total capital).

I will not take advice from salesmen
Most people hesitate to pay for independent financial advice and as a result settle for advice from brokers (or other agents) without realizing that there is an inherent conflict of interest because brokers earn a commission based on how much one invests, irrespective of the performance of one’s investment.

I will not speculate in IPOs
Companies offer shares for sale in the public-market only when people are willing to pay extraordinary prices. That is why you witness maximum IPO activity during bull market frenzy and not in bear markets. There are many opportunities to buy stocks cheap; the IPO is not one among them.

I will not use astrology to decide where to invest my money
Hundreds of academic studies demonstrate that no technical strategy can over the long term beat the simple technique of buying and holding on to an Index Fund. Yet, people are hypnotized looking at charts.

I will not blindly follow FIIs
During the hay days of 2007, private placement of shares by a company to FIIs would immediately take its share price to stratospheric levels. Today, many of the same stocks are available for a fraction of the price. Surely FII investment could be a vote of confidence for owning a stock, but not a reason to own it at any price.

I will learn some fundamentals before investing
All of us work hard to earn our pay. But when it comes to investing the money we have earned, we choose not to spend even a fraction of the time. If you think your money is valuable, it is your moral responsibility to acquire at least the basic knowledge required for making and monitoring investments.

Hunting for value in stocks

2009-05-05T16:58:00.009+05:30

Published in The Hindu - Sunday Magazine on May 24, 2009

A back of the envelope technique to spot gems during the current downturn

It is that time of the year when the CXO daddy’s and mommy’s prepare for their annual exam…ironically at a time when the kids are enjoying the holidays. Yup! I am of course talking about the annual earnings season for the Apr08 – Mar 09 financial year. CEOs and CFOs sincerely do their homework and probably even a dress rehearsal or two – first for putting on a good show at the board meeting, second for the dreaded 5 minute interview on CNBC. That’s understandable; the CNBC guys can be brutal in their grading! But for all practical purposes, their analysis is useless - especially for investors (it makes good mid-day entertainment though). The two key metrics, which they use for the scorecard– namely ‘sales growth’ and ‘profit growth’ offers a very shortsighted view and perhaps even a wrong one. The worst part is comparing the above metrics to analysts’ ‘target’ for the year. These are companies for god’s sake, not racehorses.

The first flaw with the CNBC view, something that my regular readers would have guessed by now, is that mere earnings (net profit) growth is not an indicator of stellar performance by a company. Even a totally dormant savings or fixed deposit account will produce steadily rising interest earnings each year because of compounding. The appropriate measure of managerial performance would be ‘return on capital’. The second flaw is the short-term approach, which severely penalizes even companies with a long track record of high return on capital, just because of one bad year (sometimes a bad quarter is sufficient). The combination of the two flaws results in share prices of good companies falling below their intrinsic value sometimes.

That’s great! I say. Let’s buy shares of great companies at cheap prices. Long live the stupidity and irrationality of herds (I find it hard to understand how economists actually assume that all humans are ‘rational’).

Nobody is going to let you buy shares of a ‘star’ company, right after its best innings, for cheap. Just wait for one bad year when the earnings or the growth falls below expectations (mostly for no fault of the company per se) and the same stock would virtually be available for a song.

What most people don’t understand is that good companies (i.e > 20% return on capital track record) have deep ‘moats’ to survive temporary slumps caused by external factors and can emerge back in shape. Buy their shares cheap, when there is a dip in performance and you can earn above average returns.

The Recipe

In my previous article, I discussed the ‘cheapness indicator’ for companies with high return on capital track record. Many readers asked for a step-by-step guide to use this formula, along with an example. So I have tried to provide a breakdown of the methodology along with an experiment to figure out if the stock of a leading paint company, ‘Kansai Nerolac’ (formerly ‘Goodlass Nerolac’), is worth acquiring.

• Step 1: Download company’s Annual reports for the last five years (usually available on the company website). Go to the ‘Consolidated’ Balance Sheet and Profit & Loss account (usually available in the section titled ‘Consolidated statements’ towards the end of the Annual report). A warning for those using third party sources such as Moneycontrol: the figures reported there are for ‘Standalone Company’ and hence not appropriate.

• Step 2: Calculate Return on capital for the company over last five years and take an average (Refer my article dated April 12, 2009 for the return-on-capital formula). Is the average greater than 20 per cent? If yes, proceed. For Kansai Nerolac, the average return on capital from financial year 2005 to 2009 is 23 per cent.

• Step 3: Calculate the company’s total capital at end of previous financial year (from consolidated balance sheet). Is debt capital divided by total capital less than 25%? If yes, proceed.

For Kansai Nerolac, the consolidated total capital of company, as on Mar ’08 (since balance sheet for financial year 2009 is not yet released) is 737.5 crores (Equity capital = 612.7 cr, Debt capital = 124.8 cr). Debt capital/Total capital = 17 per cent

• Step 4: Compute Total capital of company * (1+ average return on capital over previous 5-10 years)^5
For Kansai Nerolac, 737.5 *(1+ 23 per cent) ^5 = 737.5 * 2.8 = 2065 crores

• Step 5: Calculate the market capitalisation of the company (i.e share price multiplied by total number of shares). Don’t fail to add the value of unlisted preference shares if there are any (you can look this up from the Balance Sheet under Equity capital section)
For Kansai Nerolac, market capitalisation (based on Monday’s closing share price of Rs 468) is Rs 1261 crores and the company has no preference shares outstanding.

• Step 6: Compute Enterprise value = Market capitalisation + value of preference shares if any + Debt capital
For Kansai Nerolac, Enterprise value = 1261 cr + 124.8 cr = 1385.8 crores (significantly less than the five-year breakeven value of 2065 crores and hence fulfils our ‘cheapness indicator’)

The fact that the ‘Enterprise Value’ of Kansai Nerolac is at a 33 per cent discount to the benchmark on the right hand side of the ‘cheapness indicator’ formula gives us a comfortable ‘margin of safety’ to acquire the stock. Typically, companies with share prices that obey our formula are also cheap in terms of price to earnings ratio (P/E). For example, Kansai Nerolac has a P/E ratio of 12, extremely low and attractive.

The same company’s share price at its peak last year touched Rs 900, but now it is going for half the value. Why is the company trading so cheap? The only reason I can find is that they have reported a 20 per cent drop in profits. This is a clear example of the shortsightedness caused due to herd mentality of investors and analysts who are oblivious to the fact that Nerolac is a 80-year-old company and the second largest paint manufacturer in India with a 20 per cent + average return on capital over the last 15 years. If you dig a little deeper, you’ll notice that the company derives half its revenues from home paints and half from industrial and auto sector — unfortunately both sectors are experiencing a cyclical slowdown. But does it mean that the company will go bust in the next few years (reading from the share price) — something that has not happened over the last 80 odd years? Happy value hunting!

How to identify the fair price for a good company?

2009-04-21T14:53:00.006+05:30

Published in The Hindu - Sunday Magazine on May 03, 2009

The right ‘price’ is what makes a good company a good investment…

My last few articles discussed how to spot a ‘good’ company by computing the return on capital that it generates for itself. Now that you have a shortlist of ‘good’ companies, how do you determine how much to pay for such a company? As a stock investor, at what price should one acquire the shares of such a company?

The Enterprise value

Before we get into this, let me tell you how to find out what is the price at which Mr. Market (the stock market) is valuing a company as a whole, at any point in time. The share price of any company traded in the stock market is the price of one share of a company (many might think this is obvious, but I don’t!). If you multiply this share price by the total number of shares issued by the company, you get the value of ‘all’ shares of the company (the number of shares issued by the company is disclosed in the balance sheet as part of the annual report, under ‘Shareholder’s funds’ or ‘Equity capital’ section). This amount is called the ‘market capitalization’ of the company. Add the Debt capital of the company (loans and other external borrowings) to the ‘market capitalization’ and you get the ‘Enterprise value’ of the company. (Sometimes companies issue certain special instruments such as preference shares or warrants - the value of which need to be added to ‘market capitalization’ while computing the ‘Enterprise value’)

Enterprise value (value of a listed company as per Mr. Market) = Market capitalization + Debt capital = Share price * total number of shares + Debt capital

In ‘English’, the above equation merely implies that if you want to buy a company, you need to buy all the shares of the company plus pay off (or takeover) the loans that the company has borrowed from banks etc. If the share price changes, the ‘Enterprise value’ of the company changes.

Having converted the share price of a company into its ‘Enterprise value’, the next step is to find out whether the ‘Enterprise value’ is cheap enough so that you could acquire the shares from Mr. Market and reap a minimum 15% annual ‘return on your investment’ over the long term. Please note that ‘Return on investment’ as stated here is what you would make in the form of dividends and appreciation in share price post investment in the company’s shares. ‘Return on capital’ on the other hand is the return that the company generates on its ‘total capital’ (you can refer my previous article for more on this). Though the two are different, they are linked. Here’s how – the long term return to a shareholder (the return on investment) tracks the ‘return on capital’ that the company generates despite short term fluctuations of Mr. Market. Investing in high ‘return on capital’ companies at a low price produces high ‘return on investment’ for you, over many years to come.

A Golden rule for computing the ‘right price’

Now, let’s put on the hat of a business owner in order to decide whether the ‘Enterprise value’ of a ‘good’ company (that generates 20%+ return on capital) is cheap enough for acquiring its shares. After all, every shareholder is a business owner. A shrewd and conservative business owner will want to recover the cost of his investment in a project (achieve breakeven) in 5-6 years. We could use the same criterion for deciding how much ‘Enterprise value’ to pay for a company. Imagine that you are a business owner and want to acquire a ‘listed’ company as a whole by buying all its shares and settling its bank loans.

The ‘Enterprise value’ of a ‘good’ company is typically more than the ‘total capital’ of the company (i.e. equity capital + debt capital). To help you recollect - ‘equity capital’ is the money contributed by shareholders to the company at the time of shares issue plus the re-invested profits of the company till date. Companies use both equity capital and debt capital to buy assets or retain as cash for running the business. The minute you acquire a company by paying its ‘Enterprise value’, you immediately earn a portion of this value in the form of the company’s assets (or ‘total capital’) that can be sold and disposed off if need be (presuming you would be the new owner!). The remaining portion should be recouped within 5 –6 years. How are you going to achieve this?

Here is where the ‘return on capital’ track record of the company comes into the picture. Every year, the return on capital of the company will determine the additional amount that the company would earn on its total capital. These earnings can either be reinvested in the company (by adding to total capital) or taken out as dividend for you the shareholder. Either ways this would bring you closer to break-even, at the end of every year – by bridging the gap between what you paid in the form of ‘Enterprise value’ and what you get in the form of the company’s total capital + dividends. At the end of 5 years, the company’s total capital + dividends (accreted over the period) would have compounded and will be equal to the original total capital of company at time of acquisition * (1+ average return on capital %)^5. Imagine the compound interest formula and you can easily relate to this. You could even use a 6-year time frame if the return on capital track record is higher than 20%.

Based on the conservative business owner logic, you need to ensure that the price at which you buy the company (or its shares in our case) is less than the compounded amount above so that you will be able to recoup your cost of investment within 5 years.

Ensure ‘Enterprise value’ paid at time of acquiring shares <
Total capital of company * (1+ average return on capital % over previous 5-10 years)^5

This rule ensures that you don’t over pay for a good company. As long as the price at which you invest pertains to the above rule, you can be confident of a return on your investment in excess of 15% over the long term.

The God Ratio in Finance

2009-04-09T20:42:00.004+05:30

Published in The Hindu - Sunday Magazine on Apr 12, 2009

If there were one metric to measure a company’s performance that would be its return-on-capital.

In my previous article I had discussed about the Buffett philosophy of investing in high return-on-capital companies and how a high return-on-capital is a reflection of a company’s superior business model (assuming the company’s reported numbers are correct!). Here’s how to calculate the ratio and use it as a metric for choosing companies to invest-in for the long-term.

In simple terms the return-on-capital is the amount that the company generates in a year expressed as a % of the total capital that it uses. In practice, companies use a combination of equity capital and debt capital. Equity capital is the money contributed by promoters and other shareholders in return for shares in the company plus the portion of past profits that are retained in the company over the years. Since shareholders are the owners of a company, the company’s retained profits belong to shareholders and are considered part of equity capital. (Beginners, please note that companies typically retain a portion of the profits that they earn every year (for expansion) while distributing the remaining through dividends etc.).

Debt capital is the money borrowed from the bank or from other investors by issuing them bonds that carries interest charges. The ‘Total capital’ in a company is the sum of ‘Equity capital’ and ‘Debt capital’. This value can be got from the Balance Sheet of a company under ‘Source of Funds’. The ‘Source of Funds’ is split between ‘Shareholders funds’ (i.e. Equity Capital) and ‘Loan funds’ (i.e. Debt Capital).

The calculation

Return on capital (or Return on Total capital) for a company in a particular year (in %) = (Net Profit + Interest Charges) for the year *100/ (Equity capital + Debt capital) at end of previous year

For a company with zero debt, the Return on Total capital becomes equal to Return on Equity capital (in %) =
Net Profit for the year *100 / Equity capital at end of previous year

Now that you got the ‘Source of funds’ value (i.e. Total capital that the company possesses for doing business), you know what goes into the denominator of the Return-on-capital formula. Next is the numerator, which is the amount that the company generates on the total capital that it owns. The numerator, just like the denominator consists of two parts – one part is the amount that the company generates on the equity capital and the other the amount that the company pays on debt capital. The former is nothing but what we commonly see reported as the ‘Net Profit’ (otherwise known as Profit after tax) of the company. The latter is the ‘Interest charges’, which is the interest amount that the company pays to those who have lent money to the firm. The Net Profit and Total interest charges during any particular year can again be looked up from the company’s annual report, but this time not in the Balance Sheet but in the Profit & Loss (P&L) Statement.

Debt can distort true picture of company’s profitability

If you have really understood whatever I have explained so far, you must have a nagging question that must have popped up. As shareholders (who contribute to Equity capital) why should we be bothered about ‘Debt capital’ and ‘Interest charges’? Should we just not calculate Return on ‘Equity capital’ i.e. Net Profit/ Equity capital? The answer to this is that we want to know how effectively and efficiently the company is utilizing its ‘Total’ capital, so that we can decide if it is a good business or a poor business. In a way we are saying there is no color of money, when evaluating how well the company is using its money. Some companies borrow a lot of money (in financial parlance – they use “leverage”) in order to increase Return on Equity capital. But this is cheating, because all they are doing is changing the capital structure, which in no way impacts the intrinsic profitability of the business.

To understand this better, let me give you an example - say you buy a property for Rs 1 cr using your savings. After a year your property has appreciated and is worth Rs 1.2 cr. Your return on capital is 20% p.a. (no mean feat). Now imagine your friend also bought a property at the same time you did. But he did something different, along with Rs 1 cr of his equity, he borrowed Rs 4 cr from the bank at 10% p.a. interest rate and bought a property worth Rs 5 cr. At the end of the first year his property is worth Rs 5.75 cr and he decides to sell his property. After repaying his 4 cr loan with interest of Rs 40 lks, he pockets a cool Rs 35 lks. i.e. a return on ‘equity capital’ of 35%. Whose property performed better? Just looking at returns on ‘equity capital’ would give an impression that your friend’s property performed better. But look closer and you will find that the Return on ‘Total capital’ that it generated was Rs 75 lks(35 lks + 40 lks)/ 5 cr = 15%, which incidentally is poorer than the 20% that your own property generated! Your friend’s additional returns did not come from superior property selection but high leverage (or use of debt). You may ask - so what if he used leverage? He still generated better returns on his money (his equity). Yes, but he also assumed a lot of risk. What if his property did not appreciate at all, then he would have recorded a loss for the year due to the interest charges.

Incase you have drifted…this is not an article about real estate investment strategies. What I mean to say is that- for identifying superior businesses (or companies) you need to look at Return on ‘Total capital’ and not just Return on ‘equity capital’, because the latter does not clearly reflect the actual performance of the business. Why? Because, by using a lot of borrowed money one can easily boost the Return on ‘equity capital’. Good businesses do well by generating high return on ‘total’ capital – meaning they don’t have to depend on capital structure for oomph (just like how your property did in the above example).

Picking good companies to invest – the Warren Buffett way

2009-03-26T17:42:00.005+05:30

Published in The Hindu - Sunday Magazine on Mar 29, 2009

Stock picking for above-average long-term returns begins with identifying good companies to invest in.

Many aspiring investors think that buying stocks blindly based on ‘recommendations’ from others who claim to be ‘experts’ either on a newspaper, magazine, T.V or brokerage report, is ‘stock picking’. If you have still not learnt a lesson despite having lost significant amount of money already by following this technique, then reading ahead is probably too much effort that is not worth it anyway. I guess some things never change, as the 18th century philosopher Georg Wilhelm Friedrich Hegel once said - “We learn from history that we do not learn from history”.

For the others that want to really learn how to choose stocks on their own and are willing to do a little homework before plunking down hard earned money, who could be a better teacher than Warren Buffett? - The most successful investor in the world with a 40-year track record of picking stocks (and buying companies) that have generated average returns of 20% p.a (this definitely questions the credibility of the lofty claims that some of our own ‘experts’ make about generating 50%-100% returns p.a.). His approach to investing is one of the few out there, that can be termed as ‘simple’ (not to say that it is ‘simplistic’ by any means, else everyone who follows him would have become billionaires!). But, there are many who started with a few thousands worth of Berkshire Hathaway (the company run by Warren Buffett) shares that are now worth many millions. Wouldn’t it be great if you too could learn his approach and apply it to investing on your own? Actually, as utopian as the goal may seem, all the tools required for practicing investing like Warren Buffett are readily available and supplied by Buffett himself. Yes! I am talking about the letters written by Warren Buffett to his company’s shareholders every year dating back to the 1970’s. They can all be downloaded free of charge from www.berkshirehathaway.com. (psst! I happen to have some of the earlier letters that are not posted on the website, incase anyone of you is interested). These letters lay out pretty much everything that an investor needs to know including what mistakes to avoid - by learning from Buffett’s own mistakes, which have been thoroughly analyzed by none other than himself.

Buffett Philosophy

Buffett’s investment philosophy is based on ‘Buying good companies at bargain prices’. Let’s take the first part – ‘buying good companies’. How do you identify a good company? Is it the one with the highest sales growth? Highest profit growth? Highest profit margin (i.e.profit per rupee of sales)? Largest market share? The list can practically go on and on given the number of financial ratios available. But, what is ‘the’ most important parameter that helps gauge how good a business is? Before I introduce what I like to call ‘the God ratio’, let me ask you a question. What do you ask for before you put your money in a fixed deposit? It is probably “What is the interest rate offered?” i.e. “What is the return that you are going to get?” right? Well, businesses can also be benchmarked in a similar manner based on the returns they generate.

Assume you have inherited Rs1 crore, you have an opportunity to either start a business using the capital or invest the amount in a fixed deposit. You have two business ideas - one is a restaurant and other is an ice-cream parlour. After detailed research, here are your findings. The restaurant business is expected to generate Rs. 10 lks profit per annum. The ice cream parlour on the other hand is expected to generate a profit of Rs 15 lks per annum for the same investment amount of Rs 1 crore. The third option is to invest your money in a fixed deposit that will pay you an interest of 9% p.a. Which option would you pick? Obviously the ice-cream parlour, right? Why? Because it offers the highest return-on-capital i.e. 15 lks / 1 crore (15%). This is higher than the 10% offered by the restaurant business and also higher than the 9% that you would get from the FD option. According to Buffett, it is this ratio – the ‘return-on-capital’ (‘the God ratio’) that sets apart a good business from a poor one.

Fast forward into the future: your ice cream parlour is in its fifth year of operation but unfortunately you have never been able to generate more than Rs 10 lks per annum profit (i.e. 10% return-on-capital). You have tried everything you could but you just can’t seem to get the business to produce a higher return-on-capital. You look up the fixed deposit rates – they remain at 9%. What would you do? If you were a rational businessman, you would rather sell the enterprise, park you money in FD & relax, while still earning almost the same profit!

To summarise, it doesn’t pay to be in business, if the business can’t earn in terms of return-on-capital, a rate that is higher than what you could otherwise earn by just parking your funds and receiving interest at almost zero risk. So you may ask, what is the ideal return-on-capital for a business? 15%? 20%? or 30%?

Actually, I don’t know! It depends on your level of risk aversion. After all, businesses carry a higher risk than FD. So it is fair to expect a higher return. My opinion is, the return-on-capital from a good business needs to be greater than 20% p.a.

What’s so special about high return-on-capital companies?

Not many listed companies in our country have a track record of earning more than 20% return-on-capital. But still they continue expanding, by hiring more people, opening more branches, spreading abroad, acquiring companies larger than themselves using debt and just growing mindlessly, sometimes even faster than their competitors that earn higher returns on capital. How are they able to do this? The answer is…by raising more and money from the public or from other investors who are too enamoured with the ‘growth story’. But is such a growth that depends mainly on raising more capital but produces low returns on the capital, sustainable? Probably not. Even if it does, it is never going to produce above-average long-term returns to the shareholders. Because, over the long term, return on your investment in a company’s shares depends on the return-on-capital that the company generates for itself.

Companies that ‘consistently’ achieve a high return-on-capital can be considered to be ‘fitter’, as they are likely to have long-term advantages of some kind. This advantage protects them from competition and helps them continue to earn above-average profit by using relatively less capital. If you are a long-term investor who wants to buy and hold stocks, it is these companies that you want to own shares of. Having said that, you need to note that there is a gap between a good company and a good investment – it is called ‘price’ i.e the price at which you buy the shares of the company. In my forthcoming articles, I will discuss simple techniques to compute the return-on-capital for a company and to arrive at a bargain price for acquiring shares of companies that have a track record of ‘consistently’ generating high return-on-capital. This combination of buying above-average companies at below average prices will help you to reap above-average return on your investment for many years to come.

Impact of the economy on the marriage circuit

2009-03-09T21:47:00.005+05:30

Published in The Hindu - Sunday Magazine on Mar 15, 2009

Investment Bankers and IT professionals who until recently were the darlings of the marriage circuit have suddenly become the most unloved.

Young Investment Bankers and IT professionals have probably never had it worse in their lives. As if the uncertainty on the professional front is not sufficient, they are getting hammered on the personal front as well. The community that was once unanimously accepted to be a honey pot of the most eligible bachelors in the country suddenly seems to have become a quarantined group that prospective father-in-laws are hesitating to consider. Do they deserve this?

Before you come to any pre-conceived conclusion let me right away quell any speculation about my involvement in any kind of marriage broking activity. I will make one confession though – I have been offering pro-bono marriage related ‘advice’ to fathers of ‘brides-to-be’, especially when the groom in consideration is an I-Banker or an IT professional. Ever since I wrote about the Investment Banking friend who helped inaugurate the global financial crisis and got himself fired or the IT hotshot missus who waged a war against cost cutting measures at her company (before her own job became endangered), many readers have upgraded me (or downgraded, based on your opinion) from the status of a financial consultant to that of a marriage consultant!

The fathers of ‘brides-to-be’ seem to have suddenly turned paranoid against professionals in the IT & financial sector, or at least that’s what I can infer from the emails I receive. This would mean the world (of marriage) is finally flat for all those non-finance and non-IT types. Who knows, given the current state of paranoia, it could soon turn out to be a deja-vu of the 70’s when only the Government/ PSU employees are the most sought-after.

But in a way the whole scene is so sad. Frankly, I don’t think it’s healthy to give such a heavy weightage to the bride/groom’s profession when it comes to marriage. It’s after all a job, you know. If not this one, there’s always another one. If not now, a few months down the lane. Anyone who is literate enough to be able to read this column can get a job or even better create job(s).

There are so many other attributes that are more important when it comes to choosing a life partner than just the financial position or the job description of the groom/ the bride. Some of you may think it’s naive to suggest that money is not important, that too coming from a columnist who writes about money. Of course money is important, but it’s largely a function of one’s expectations. I just think there are other things in life that are even more important and essential, especially when it comes to matrimony.

Whether it is investing or life, when in doubt – I refer to the legendary Warren Buffett. Inspite of him having made it big financially as an ace investor (for those unaware - he’s the world’s richest person), he seems to think that it’s not money that gives true happiness but it is one’s life partner. I guess at the end of the day that’s who we would share our most memorable moments and spend significant time with, with or without money. Here is an excerpt of Mr.Buffett’s informal Q&A session with MBA students at the Richard Ivey School of Business in Canada. It is a must read for every prospective bride, groom and their fathers.

Warren Buffett on choosing a life partner (transcript)

“What can you possibly do with billions of dollars? The problem in life is not getting rich, but finding simple things you enjoy and living a normal life. The most important thing is finding the right spouse. If you make the wrong decision on that you will regret it, there is a lot of pain involved; but if you have the right spouse it is just wonderful. What qualities do you look for in a spouse? Humour, looks, character, brains, money or just someone with low expectations? The most important decision that you will make is that. If you make that one decision right I will guarantee you a good result in life.”

“One of the things I use with students is I ask you to imagine that I am going to give you an hour and in that hour you have to pick one of your classmates to own 10% of for the rest of your life, or even better someone whom you have to work with for the rest of your life and another person whom you would short-sell or disassociate yourself with. Now, on the buy-side you list the qualities of the person who you want to own a share of or partner with and on the sell- side you list the qualities of the person whom you want to disassociate yourself from. On the buy side, you won’t necessarily pick the person who is richest, first in your class or the one with the highest IQ; you will pick out the human being that is going to be effective, sincere, generous, humorous and forgiving. On the sell-side, you would pick the person whose qualities turn you off. It could be selfishness, hypocrisy, envy, short temper or any other negative attribute. It is such an elementary proposition.”

“Everybody, absent some terrible illness or tragic death, has a passion for happiness. A spouse is the most important thing. It is important to have a job you love, its not so important how much you make at it.”

- End of transcript –

For those in the marriage circuit, my advice is - don’t be carried away by the short-term impact of the economic slump on certain sectors when you are short-listing your life partner; instead, what you need to focus on is the long-term aspects of matrimonial life, which tends to be determined by individual human qualities & compatibility. Moreover, while the IT and financial services sectors may be undergoing the worst slump at this point, life’s not really a breeze in the other sectors. One thing to remember is that the world is not going to come to an end – contrary to what some analysts and certain economists would want us to believe. Things will recover, the stock market will bounce back, most companies will survive, people would be able to get a job commensurate with their training (even if that means a temporary salary cut) and life will go on.

Life lessons from Satyam

2009-02-28T14:28:00.003+05:30

Published in The Hindu - Sunday Magazine on Mar 1, 2009

The pursuit of ‘success’ at the cost of moral virtue may offer immense financial wealth but rarely happiness or peace of mind.

Caution: Philosophy ahead! A life driven with blinkers, in search of the popular definition of ‘success’, namely - money, fame and power, begets cancerous greed that can potentially invade even the basic moral values, enslave us to peer pressure and leave us with a permanent sense of insecurity. The dogged pursuit of such a ‘success’, largely governed by external parameters, comes with an enormous cost - ‘happiness’. As an alternative, doing what we love and doing it with a clear conscience can help achieve a better version of ‘success’, which is internal to us, is more fulfilling and leads to a happier life.

Down slippery lane

Much has been written about the Satyam saga, since the day Mr. Raju published the sensational story about the tiger’s tail. Sadly, what I have not heard so far is an analysis of what is it that fundamentally drove Mr. Raju to perpetrate this? Does this event raise an alarming sign of something much deeper engulfing our society, given the increasing number of corporate scandals across the world? Are we to blame? What are the broader lessons for the next generation?

I have never met Mr. Raju, nor do I know anything about his personality, his ideology, or the circumstances that prompted him to go down the slippery slope. But it appears there were two fundamental attributes that governed his actions 1) desire to maximize wealth and power for himself and his family with scant regard for the other stakeholders 2) not minding about being dishonest and unethical in order to achieve the above purpose. Although the full extent of financial activities that went on behind-the-scenes is yet to be unearthed, it appears that they constitute one or more of the following: funneling out cash from the parent company, establishing a shady nexus with state politicians, cooking up bogus numbers to keep performance in line with leading peers while gradually reducing personal shareholding, investing company’s wealth in personal real estate holdings, patronizing the son’s firm at the cost of the parent. All of these actions (if proven), can be linked to either of the two fundamental attributes of Mr. Raju & Co, listed above.

Hoarding personal wealth, sure, but to what effect?

Let’s take the first attribute- “hoarding of personal wealth gaining precedence over all else”. Aren’t most of our lives driven by this shallow goal? As employees (including non-owner CEOs), how many of us really care about the long-term performance of the company that we are working for? Aren’t most of us just interested in getting our salaries, bonus or stock options and making most money for ourselves in the process, as quickly as possible?

It is these attitudes that led to the collapse of Wall Street and brought the global financial market to its knees. CEOs and staff in leading investment banks and hedge funds acted in a way that would maximize their year end bonus, with little regard for how their actions would come back to haunt the firm in the future. And now the same guys are crying about losing their jobs! What an irony!

With promoters (such as Mr. Raju), there is a different problem. Very few seem to care about the faith and the trusteeship responsibility imposed on them by external shareholders, after the IPO is completed. So instead of focusing on whether the company is managed efficiently for the benefit of ‘all’ shareholders, they are more interested in making use of the company to make more money for their own family. This gives way to all kinds of creative practices, which may or may not be illegal but is definitely unethical. Looking at the extent and variety of questionable practices adopted by promoters of publicly listed companies, I really feel this is not a regulatory problem but an attitude problem.

Passion is better than greed

The one-dimensional approach of employees and promoters who believe “personal wealth maximization alone matters” only leads to selfish greed. But, greed is bad! Not only for the society but also personally. Irrespective of what Michael Douglas may profess in the movie “Wall Street”, the problem with leading a life purely for the sake of personal wealth & power is that even when you have it, you either want more of it or you are afraid of losing it and hence never “happy”.

What is necessary for a strong economy and a fulfilled life is that every employee and promoter should be driven by passion and not greed. A passion to expand knowledge, to improve people’s quality of life or to just be part of building and growing an institution that will outlive you. A passion to love your job and not only your title, net worth, salary or perks. And above all, a passion for promoters to genuinely share the wealth - with shareholders, employees and the community, instead of just focusing on expanding the family’s net worth.

Clear conscience – the secret to sustainable happiness

Now, let’s take a look at the second attribute of the Satyam imbroglio - “not minding about being unethical in order to achieve greater personal wealth and power”. I for one cannot think of a better end goal in life than “happiness”, so I believe that even when people go crazy in the pursuit of extraordinary money & power by acting against their conscience, they do so only to attain “happiness”. If this is a fact, they can’t be more grossly wrong in their means.

Scientific research has proven that the average human has an innate morality, a fundamental sense of right & wrong that is much deeper than all our cultural, judicial or religious adaptations. Apparently, this internal “moral compass” in our brain will not let us stay happy without having a clear conscience! Although this compass can be overcome in the short term by the desire for money, fame, power or other pleasures; by feelings of anger, revenge, fear or external pressure; or by self-rationalization, the compass normally resurfaces to annoy us over the longer term (unless we suffer from mental deficiency). Experimental findings indicate that people can clearly recollect the incidents where they acted amorally, many years later, as these are deeply imprinted in the mind.

An extension of this human trait is our desire to cleanse ourselves of past amoral actions. We try to achieve this through many avenues – religion, donation, service-to-society or some even through suicide. And all this only to “feel good” about ourselves i.e. attain “happiness”, if not in this life at least in the next. (Wonder what were the transactions between Mr. Raju and Tirupati)

The existence of a “moral compass” has been validated by incidents of voluntary public confession by people, especially as they grow older, about acts committed much earlier in their lives. When enquired about their reason for coming clean despite the potential blow to their reputation, they said - they just wanted to sleep peacefully at night. I guess Narayana Murthy’s famous saying about a clear conscience being the softest pillow in the world is true afterall. (Sweet dreams Mr. Raju)

As citizens of Corporate India, let’s try do the right thing, if not for others at least for our own happiness.

Have you been cross-sold?

2009-02-06T14:41:00.002+05:30

Published in The Hindu - Sunday Magazine on Feb 15, 2009

By understanding the behavioral psychology of customers, sales personnel have got smarter in using cross selling and up-selling tactics masquerading them as customer service.

Last week, an old friend of mine was in the city for a day and we decided to catch up before he took his return flight back. We picked a Café Coffee Day outlet for the rendezvous as opposed to a dreary Hotel coffee shop. The good things about the mushrooming of coffeehouse chains like Café Coffee Day or Barista are a) they make good meeting places - anytime during the day or night (up to midnight) b) you can sit as long as you want c) they are scattered all over the city d) they are easy to locate for out-of-towners. In fact, I don’t think anyone comes to these outlets just to have coffee…maybe it’s just an excuse for sitting around in plush leather couches, listening to good music and chatting or working on your laptop in air-conditioned comfort.

So we met in the evening and got talking. We decided to act courteous by ordering something although neither of us was really hungry. It was one of those hot days in Chennai (which is pretty much most days), so we thought we would quench our thirst and at the same time get injected with a shot of caffeine by ordering a cold coffee.

How we became an easy target

We beckoned to the waiter and were supposed to give our order i.e 2 cold coffees, but here’s what happened:

Waiter: Good evening Sir, how are you doing today?

Us: Fine. Thanks.

Waiter: Sir, our evening special for the day has just got ready, would you like to try it?

Us: What is it?

Waiter: Warm chocolate doughnut.

Us: hmm…okay. May be 1/ 2?

Waiter: Sir, it is quite small, just palm sized.

Us: okay, then we’ll have two of that

Waiter: with some whipped fresh cream on top?

Us: (hmm…sounds creative) okay

Waiter: and your drink order sir?

Us: 2 cold coffees please

Waiter: with ice cream or fresh cream? We have vanilla and chocolate.

Us: (not cream again…) one with vanilla, one with chocolate.

Waiter: Sir, would you like some chocolate gratings on your vanilla ice cream?

Us: (hmm…) okay

Waiter: How about you sir (looking at my friend), would you like some crumbled cookies as a topping on your chocolate ice cream?

He: Okay.

Waiter: Thanks Sir, I’ll be right back with your order.

After the waiter went away, my friend and I just stared at each other. I guess both of us realized what had happened. But it was too late. We got “cross-sold”. We just wanted to buy two simple plain cold coffees, but the waiter had politely managed to tempt us into ordering much more than what we planned to. How could two intelligent people fall prey to this textbook salesmanship? Well, what can I say - “it happens”. When we got the final bill, we realized that had we stuck to our original choice, we would have paid only one-third of the bill amount! The waiter had achieved two things: one - he made us order something in addition to just coffee (this increased the revenues), two – he made us choose the paraphernalia like the crazy cookie topping (which no doubt cost less in absolute terms but boosted the profit margin)

Cross-selling to existing customers easier than acquiring new customers

The fact of the matter is that customer service oriented organizations, especially those operating in the restaurant business, in the financial services business and the telecom services domain, have realized how easy it is to increase their revenues and profit margins by selling more to their existing customers rather than seek out new customers.

You may find it interesting to know that restaurants make a higher profit margin on the dessert and soft drink compared to the main course. You might have noticed that Pizza Hut never serves water. That’s because they want you to order Coke, which they could have the pleasure of serving in a short glass with lots of ice and a slice of lime for a 400% margin (Wow!).

Larger organizations have set up separate cross-sell divisions to come up with ideas – either to upgrade existing customers to more expensive schemes within the same product line or to sell them an entirely different product line. For example, you may start by opening a salary account with HDFC Bank and before you know it - you own HDFC Silver credit card, a HDFC Health Plus Card with free EMI facility and a HDFC personal loan. The next time you walk into the branch, an executive is asking you to invest in a HDFC ULIP (Unit Linked Insurance Plan) to avail of annual tax savings and get insurance ‘free’ (yeah! right). Then you get a call from a customer service executive saying you have now been ‘chosen’ to automatically upgrade your credit card from ‘Silver’ to ‘ Platinum Plus’ with zero joining fee, as a recognition of being a special customer (conveniently omitting any talk on hidden charges). Platinum definitely sounds better than Silver, and you are getting it free! So you join - only to realize a year later that you are paying a hefty annual fee. Soon you get sucked up in a vortex of EMIs, secret charges and paltry investment returns, and then you suddenly get a bolt from the blue that makes you wonder – “why the hell am I stuck in a compulsory monthly investment plan, when I am running multiple loan EMIs on the other side?”

I don’t want to sound dramatic but it’s true! People who take a loan to make their ends meet are sold expensive insurance policies or investment plans and many take it even without independently evaluating whether it is required in the first place. Even worse, some customers are made to think that it is mandatory that they sign up for the insurance policy in order to avail of the loan. To make these cross-sell schemes more appealing, you are charged a single combined EMI for your loan, insurance plan etc., making it impossible for you to even differentiate how much you are paying for each of your commitments separately.

Watch out!

So, why has ‘cross-selling’ and ‘up-selling’ become so rampant lately? In my opinion, its success can be attributed to three factors: a) the high incentives for sales staff to cross-sell & up-sell b) the irrationality of customers (although economists believe the contrary) to do crazy things that defy logic when coaxed by well-sounding advice c) the ignorance of customers.

The next time you are short-listed for a ‘special scheme’ or ‘exclusive offer’ for being a valued customer, you know what to keep in mind. About the waiter in the restaurant affectionately tempting you to go for the dessert – I will leave it for you to decide if he is just trying to display his hospitality or if he has a hidden agenda to increase the profit margin.

Guaranteed Return Scheme…anyone?

2009-01-28T12:47:00.003+05:30

Published in The Hindu - Sunday Magazine on Feb 1, 2009

Despite the proliferation of Guaranteed Return Schemes that offer tax waiver, term life insurance and investment benefit, the fact is that they come with many hidden clauses and hefty charges. This tax season, with the stock market at rock bottom levels, investors will be better off investing directly in ELSS mutual funds (Equity Linked Savings Scheme). Those seeking life insurance security must enroll into a separate pure risk term cover life- insurance plan in addition to their ELSS investment.

‘Guaranteed Return’ schemes are either single premium or annual premium insurance plans. It seems the rise in popularity of ‘Guaranteed Return’ schemes is four fold: they offer tax benefit, they offer insurance cover, they provide investment returns (with either fixed return guarantee or minimum maturity guarantee over a 5 yr or 10 year lock-in period), they levy hefty charges (for the insurance company/ agents to pocket). Let’s evaluate by taking the features apart:

Tax Benefit (the only good thing about the schemes)

Not only is the premium that you contribute (either upfront or on an annual basis) eligible for exemption under section 80c, the maturity value is also exempt from tax.

Death Benefit

The single-premium ‘Guaranteed Return’ plans (including the superhit Jeevan Aastha) typically offer little cover in terms of life insurance compared to the premium amount. Beware of tricks that claim high first year insurance cover that drops to a fraction by the end of the term (that’s crazy! Ain’t it?). I guess after enrolling in the scheme, one needs to kick the bucket ASAP in order to avail of maximum benefit. Some single-premium ‘Guaranteed Return’ ULIPs (Unit Linked Insurance Plans) that do offer higher insurance cover deduct the corresponding ‘mortality charges’ upfront. That means the insurance cover is not ‘free’ as your agent would make you believe.

The other variety: annual-premium ‘Guaranteed Return’ ULIPs, offer a ‘death benefit’, which is usually either the fund value only (as on date) or the sum of fund value and ‘sum assured’ (insurance claim). The first option is not insurance really and the latter option comes with a high ‘mortality fee’ (monthly or annual charge in return for the insurance cover).

The question is: if you are anyway going to be charged for your insurance, why don’t you just pay the relevant fee (or probably even a lesser amount) and take a separate pure risk term insurance plan? What’s the point in jointly taking insurance along with the investment scheme?

Lacklustre Investment Returns (after netting off charges)

Some single premium ‘Guaranteed Return’ plans (such as your Jeevan Aastha or Aegon Religare Guaranteed Return Plan) offer fixed post tax investment return of around 7% p.a. over a period of 5 to 10 years. For those in the highest tax bracket, this translates about 1% higher annual post tax returns compared to 5 year Bank FD or NABARD bond, which are also eligible for 80c tax deduction. This is because investors in Bank FD or NABARD Bond have to pay a tax on interest earned at time of maturity (computed based on tax slab). For lower tax brackets, the 1% return differential pretty much disappears. Either ways, I don’t think there is anything to salivate over, at least not to the extent the schemes are promoted. You could invest in a PPF (upto Rs 70,000 p.a. with 80c deduction) and get 8% p.a. tax-free returns.

Other single premium ‘Guaranteed Return’ plans are ULIPs e.g. Bajaj Allianz Capital Shield, which offers a guaranteed maturity value after a 5-year term that is equal to your first premium amount! Can you believe that! This means they don’t even guarantee fixed-deposit returns on your premium. Their argument is that this is only a minimum guarantee i.e. you will reap higher returns from this scheme if the stock market goes up, as they would invest your premium amount in mutual fund(s). It doesn’t take a genius to figure out that the stock market will definitely go up over the next five years as long as the world doesn’t come to an end! Then why do you need this scheme? You could directly invest in a mutual fund at a much lower cost! Speaking of cost, the charges for the scheme are as follows: 2% one-time premium allocation charges, 2.75% p.a. recurring fund management charge, 2% withdrawal charge at maturity. This is in addition to the separate mortality charge that you have to pay for the life insurance cover.

The annual premium ‘Guaranteed Return’ ULIPs typically require you to pay premiums for a minimum of three years and allow withdrawal of funds after 5 years lock-in. Just like the single-premium ULIPs (discussed above), these plans also invest your premiums in mutual fund(s) and offer a minimum return guarantee – but only on your first premium! Even this guarantee becomes meaningless if you account for the charges. So here again investing directly in a mutual fund seems to be a better and cheaper option.

The recently launched ICICI Prudential Return Guaranteed Fund or ‘RGF’ is a good example of how charges diminish ‘guaranteed returns’. One unit of the RGF is available for Rs 10 NAV with a guaranteed return of Rs 15 NAV (50%) after 5 years. This wonderful scheme (I am kidding) can be availed if you enroll in their annual premium ULIPs: Life Stage Pension or Life Stage Gold. All right you may say! Atleast I am getting 50% minimum guaranteed returns for my first premium. The answer is ‘no’, because only a portion of your first premium is used towards purchase of units. About 20% of the premium is deducted towards premium allocation charge! That means although you expect a total return of 50% (Rs 10 NAV to Rs 15 NAV after 5 years), your effective guaranteed return after charges would be much lesser – close to 20% after 5 years. That’s a pathetic guarantee! You would earn more in a Bank FD.

Furthermore, some of the other charges such as policy administration charges (6% p.a.) and mortality cover are deducted by cancellation of units. That means you won’t even realize it: while you keep your focus on the rising NAV, the number of units will gradually keep reducing over the years! It is almost as if you can call the product ‘Charge Guarantee Scheme’ instead of ‘Return Guarantee Scheme’.

Summary

‘Guaranteed Return’ insurance plans neither offer return guarantees that are significantly better than other fixed return instruments (such as Bank FDs, PPF etc) nor cheap insurance cover. In fact the ULIPs that offer these schemes just invest in mutual funds. So, why pay extra charges and succumb to hidden clauses?

The best and the most lucrative use of your capital for this tax-planning season is to directly invest in a well-established ELSS mutual fund. These carry very low charges when compared to the ULIPs or other ‘Guaranteed Return’ Insurance cum Investment plans. Just because you made the wrong decision of investing in the market at the peak it doesn’t mean you should shy away from making the right decision of buying when it is cheap!

If you are concerned about ‘death benefit’, buy a dedicated life insurance policy – a pure risk cover without the bells and whistles of endowment, investment, money back, ‘guaranteed return’ etc. That way you can pay a low premium and you know exactly what you are getting. eg. LIC’s Jeevan Anmol offers a pure risk term cover. If you are a 30 year old, for a single premium of Rs 8,300 or annual premium of Rs 1, 200 you can get a 10-year term life cover of Rs 5 Lakhs (i.e 400 times your annual premium or 60 times your single premium).

Behind the scenes

2009-01-13T23:08:00.003+05:30

Published in The Hindu - Sunday Magazine on Jan 18, 2009

With retail distribution channels, financial advisors, agents and brokerages playing a vital role in your day-to-day transactions, their commissions are increasingly determining your choice – be it groceries or mutual funds.

Henry Ford, who is still considered the father of the modern automobile industry despite his firm (Ford Motors) hitting rock bottom in the recent economic turmoil, made a famous statement at the launch of his first factory made car – the Model T. When asked how many colours the car would be produced in, his reply was – “you can have any colour, as long as it is black”! Until the liberalization in the 90’s the Indian scenario was pretty much the same with consumer choice being limited to standardized products offered by few companies (meaning two or three) at best – be it cars, toothpaste or even mutual funds.

With the seeming explosion in product variety that is visible in recent years (as seen in the media) - it is easy for you to come to a forgone conclusion that the consumer is really the king and can finally buy whatever best suits his/her tastes or requirement. Well, sadly you are wrong.

A revelation

This article is the result of a revelation (I would rather call it disillusionment) from my recent shopping escapade at the neighbourhood outlet of a large national super market chain. The missus having left the country on a ‘business trip’, I was free to wander the store aimlessly with no list in hand, just checking out what’s new (especially the ready to eat stuff). As I was staring at the freezer, I had an epiphany. Firstly, the essentials like curd, cheese etc… where only available in large SKU’s (stock keeping units or package size). Secondly, many products were restricted to single brand (or company). I quickly did a survey of other sections in the store, and I could sense that under every category there were one or two preferred brands that were being promoted by the store. Curd – Britannia, Milk –Heritage, Cheese – Britannia, Ghee –Hatsun, Water- Cherio, Masala – Eastern, Powdered beverage - Horlicks and the list goes on. The other leading brands that offered these products were either non-existent or strategically sidelined (in a corner, with very few variants displayed). Interestingly for some products, such as rice, sugar, salt etc. the ‘inhouse’ store brand (i.e the retail chain’s own brand) was the most prominent.

The situation demanded a quick call to my friend who works for a FMCG (fast moving consumer goods) firm. The chat revealed just what I feared. With the growing footprint of national retail chains, they are able to offer a unique selling proposition to the consumer goods companies- near monopoly for the one who offers highest percentage commission. The retailing chains believe that customers (you and me) are reasonably loyal to their neighbourhood super market due to the proximity (it is close to the home), ability to shop in peace and leisure (air conditioned aisles etc..) and availability of all products (not necessarily all brands) under one roof. Once inside a store, as long as the particular product is available, customers are willing to trade off one brand to another, based on availability. This means that although you may actually want Amul curd, if the store has only Britannia curd, you are more likely to buy the Britannia curd instead of going to another store to pick up Amul (the one you like). This apparently holds true even if Britannia curd would be a couple of rupees more expensive than Amul, because you justify that a trip to another store merely to pick up one item is just not worth it.

Retailers exploit the above-described psychology of customers by carrying only those brands that pay them maximum commission, under every product category (and price band). In effect the end customer is successfully deceived into buying the product that the store wants him to buy, while the whole point of him visiting the supermarket was so that he could buy whatever he wants! Next time you find your favourite brand repeatedly unavailable in the supermarket, try asking the store-helper. You will either be told that the particular item is out of stock or that the item is not being supplied off late – as if the blame is on the supplier!

This phenomenon of the retailer selling you only those products for which he gets a higher commission is particularly pronounced in the financial services industry. You will be surprised to know that most financial advisors (and/or agents, brokers) also work on the same model. Commissions (paid out of your investment amount) are the answer to the following riddles when it comes to investment instruments:

Why are ULIPs (unit linked insurance plans) more popular than term cover or pure mutual funds (including ELSS – tax saving schemes)?

Mutual funds deduct not more than 2.5 per cent as the agent's commission. And this deduction is 0 per cent (by law) if investors don’t use an agent and go directly to a fund company. In ULIPs, the agents' commission varies, but in the first year, it could be anywhere between 25 per cent and in some cases, 75 per cent.

A ULIP is technically a combination of term cover insurance and a mutual fund i.e one portion of your annual payment goes towards the insurance policy and the other portion is invested in stocks or debt. But the commission that an agent gets by selling a ULIP is many times what he would get by selling the equivalent term cover and mutual fund separately.

Why are single premium insurance plans not as popular as annual premium plans?

For a single premium plan the upfront agents’ commission is 2%. For annual premium plans, not only does the agent get an initial commission of 35% -40% in the first year, but he also gets a commission every ensuing year during the term covered, in the order of 5% - 7.5%.

Why are equity mutual funds more popular than ETFs (exchange traded funds)?

ETFs can be directly purchased on the stock exchange just like buying a stock. So, other than the minimal brokerage fee (0.1%) there is no commission involved in purchasing ETFs. This explains why index exchange traded funds (discussed in my previous article dated Jan 4, 2009) are not very popular compared to regular mutual funds despite their low risk and high returns.

Why are banks interested in selling gold coins rather than gold ETFs, although the latter is safer and offers better liquidity?

Banks earn 8% distribution commission on gold coins.

Among mutual funds, why are NFOs (new fund offers) more popular than existing schemes?

NFOs offer higher commissions to agents (both monetary and non monetary: foreign trips and attractive ‘gifts’) than existing schemes.

Why does your agent advise you to churn your investment from one fund scheme to another, every few months?

Mutual funds pay an upfront commission of up to 2.5% to agents for getting you to invest in the scheme. Once you have invested in a fund, then all that the agent gets is a paltry trail commission of 0.5% every year you stay invested in the scheme. Your agent need not be a math wizard to figure out that he can earn more (2.5% > 0.5%) by getting you to churn your investment into a new scheme.

The next time you call your financial advisor for a tax saving mutual fund scheme and find that he recommends a ULIP, you better watch out!

The safe way to invest in the stock market

2008-12-31T09:04:00.019+05:30

Published in The Hindu - Sunday Magazine on Jan 4, 2009

The NIFTY Exchange-traded Index-fund offers a low-risk alternative to stock picking and mutual fund selection. Coupled with a simple rule to decide when to buy & when to sell, this instrument helps you reap better than average returns without the associated headache.

“Tall Decaf Double Expresso, one shot low-fat cream, no milk, extra foam” – this is a regular customer order at Starbucks (Starbucks is a popular coffeehouse chain in the United States). Every word in the order indicates a choice made by the customer, from the multitude of options available. If you are not sure about your preferred concoction (I mean memorized it), the consequences are: a) you get stared at, as if you were from another planet b) you are put through a rapid-fire of multiple-choice questions to which you need to guess the right answers c) just because you paid for it, you end up having to finish a 200 ml serving of unsatisfactory coffee (out of a super-size mug) that you never intended to order in the first place. I really wonder: what’s the purpose of racking your brains by making six decisions just to buy one cup of coffee

Tall, Grande, Venti, Misto, Americano, light roast, dark roast, pike-place roast, caf, decaf, low-fat, non-fat, cream, milk, foam – with so many permutations and combinations possible, it is not uncommon for the uninitiated to burn a hole in the pocket, in search of an output that is at least mildly close to the simple filter-coffee, which one takes for granted back home. The curse of choice only gets worse when you walk into a grocery store: 5 types of milk, 6 types of orange juice, 7 types of bread, 8 types of cheese and the list goes on. Back in India, I am glad we have not yet reached the level of ‘sophistication’ (or ‘confusion’, depending on how you feel) that our American friends take pride in. But it appears we are soon catching up - if not with our own Café Coffee Day, at least with our investments.

In my previous article, I had discussed the simple way to ensure profitability in stock market investing, is to buy when the P/E ratio (price to earnings ratio) of the index is below 15 and sell when the P/E ratio rises above 25 (the P/E of the NIFTY Index as on 26th Dec 2008 is 12.5). But after having decided when to invest in the stock market, the increasingly complex question is - where to invest? Thanks to the number of IPOs and NFOs that sprung up over the last four years, today we have around 1300 stocks traded in the National Stock Exchange (an even greater number is available in the Bombay Stock Exchange), 400 odd equity mutual fund schemes and of course there are the ULIPs (Unit Linked Insurance Plans), which are basically mutual funds wrapped with insurance cover.

With so many options available, how does one decide where to invest? One option is to use the trial and error approach (similar to my coffee experience), but given our commitments and our rather restrictive lifespan - I don’t think you would want to experiment with your hard-earned (and even harder to save) money. The other option is to listen to the ‘analysts’, but with the abundance of ‘buy’ recommendations out there, you will either need cartloads of money to invest in every recommendation or you have to use your gut feel (my neighbour thinks numerology is quite effective) to decide on which recommendations to bet your money on. Those who think they can do a better job than the ‘analysts’, can of-course conduct their own financial analysis before deciding which stock or mutual fund to buy – but I doubt if many have the time for this.

Wouldn’t it be great if there were just a single investment instrument, through which you can safely invest in the stock market? Luckily there is one, and it is called the NIFTY BeES (Benchmark Exchange-traded Scheme) – one of the largest and most liquid exchange traded funds (ETF) in India. The price of one unit of this fund (akin to your mutual fund’s NAV) is equivalent to 1/10th the value of the NIFTY Index. When the value of the NIFTY Index appreciates, the fund’s price goes up proportionately and vice versa. Through the NIFTY BeES, one can directly buy the NIFTY Index.

What’s the benefit in buying the NIFTY Index? The NIFTY Index (similar to the Bombay Stock Exchange’s Sensex) is the flagship index of the National Stock Exchange of India – the largest stock exchange in the country in terms of number of transactions. The value of the NIFTY Index represents the weighted-average share price of some of the largest companies listed on the Exchange. These include pretty much all the front-runners of our economy. The 50 stocks that constitute the NIFTY Index represent 21 sectors of the economy and make up nearly 70% of the total market value of all stocks listed on the Exchange! Buying the NIFTY Index is equivalent to buying the shares of all these 50 companies put together. The NIFTY BeEs helps you do just that but with minimal investment e.g. if you were to buy one share in each of the 50 stocks in the NIFTY Index, you would have to shell out Rs 21,725 as the minimum investment, whereas one unit of the NIFTY BeES is available for just Rs 285.7 (based on Dec 26th, 2008 - closing price)

Why is the NIFTY BeES safer than any single stock investment?
Well, the answer is simple. Individual stocks are subject to stock specific risk (e.g. the promoter could suddenly mistake his company to be his personal ATM, such as what happened with Satyam Computers) or sector specific risk (e.g. the impact of oil price slump on Reliance Industries). Since the NIFTY represents multiple stocks across multiple sectors, you are well diversified.

Why is the NIFTY BeES safer than a mutual fund?
First, there is an increasing number of specialized or sector specific mutual funds (e.g. Real Estate & Infrastructure only), which actually go against the basic concept of mutual funds i.e. diversification. By investing your money only in the ‘hot’ sectors, these funds actually expose you to the risk of incurring significant losses in the event of a ‘bubble burst’ (remember the Real Estate bubble in the U.S.). The NIFTY Exchange-traded Index fund on the other hand, ensures that cross-sector diversification is achieved. Broad-based mutual funds that take a balanced approach to investment also provide good diversification benefit, but at a comparatively higher cost.

Second, the returns from a mutual fund are partly dependent on stock selection ability of the Fund Manager. When a fund manager leaves, one cannot guarantee if past performance of the fund (based on which you would have invested your money) is likely to repeat itself. Moreover, as an investor it is impossible for you to know what stocks the fund would invest in, pre-facto. Whereas in the NIFTY BeES, the investor knows exactly where his money will be invested – in the 50 stocks that make up the NIFTY Index! You too can check out what stocks constitute the NIFTY Index by following the trail: www.nseindia.com> Indices> IISL Indices> S&P CNX Nifty

What about entry and exit load?
There is no entry or exit load for the NIFTY BeES, and the annual expense ratio at 0.5% is among the lowest compared to other mutual funds.

Any other advantages compared to regular mutual funds?
Mutual fund investments can be made only based on the day’s closing NAV. Exchange traded funds can be bought or sold at any point during the day at prevailing Index levels. This means you could also trade intraday (not that I recommend this).

Okay, I am convinced – how can I buy the NIFTY BeES?
Buying and selling is very easy. You just need to have a demat account - your stockbroker can open this for you. You may then call your broker over phone or use your online trading account to buy and sell units of the scheme, just like any other stock. The NSE code of the fund is NIFTYBEES. For more details on the NIFTY BeES, visit www.benchmarkfunds.com

Wish you a Happy and Fiscally Fit 2009

The Simple way to invest

2008-12-07T11:06:00.005+05:30

Published in The Hindu - Sunday Magazine on Dec 7, 2008

What the recent stock market fall (and every preceding one) has shown is that it is critical to decide when to buy and when to sell in order to save the heartburn and yet reap above-average gains. How does one realize this seemingly utopian desire?

The steep fall that the Indian stock market has witnessed over the last few months has no doubt spooked even the professional investors. The worst hit are the ones who invested a significant portion of their wealth in the markets at the peak (Jan 2008) – be it in individual stocks or mutual funds or ULIPs. The only comfort that stockbrokers seem to offer to these once faithful clients, who have seen the value of their investments shrink by more than 50%, is that this time it is a global phenomenon and no country has managed to escape the meltdown in asset values (I really wonder how a guy in China losing his money is supposed to make me feel better). It is ironical that the months preceding the start of the great fall saw the most number of fresh IPOs (Initial Public Offers) and NFOs (New Fund Offers). The daily calendar for the active investor was filled with a new issue opening, closing or listing. Every opportunity seemed so rosy (or at least projected to be) that the retail investor was utterly confused about were to invest his money. Eventually one ended up investing a little bit of money in everything.

Fast-forward six months, and today you realize that it didn’t matter which stock or mutual fund or ULIP you purchased, they have all dwindled to a fraction of the original value. SIPs and MIPs are no better. Some sectors –especially the most hyped ones such as Infrastructure and Financial Services have been the worst hit. So, what are the consequences of losing all this money?
1. We sell some of our holdings and vouch not to put even a single paisa into the market henceforth
2. We try to reach stockbroker to curse him, but he is untraceable.
3. The Pay-cheque gets seized by the missus. Hidden hand of In-laws suspected. Or may be it was the last NFO (ironically named R.I.C.H fund) that was purchased using the money saved for a vacation.

All this gives me an ominous feeling that we will always be against the cycle, like a hamster in a vicious wheel. In all probability, as soon as the market recovers and we are able to recoup our costs, we will once again invest in the market seduced by the fresh Bull run and stories of how the new neighbor has made a tonne in stock futures & options. What we fail to realize is that we are setting ourselves up for failure, time after time, by “buying high and selling low”. This is against the cardinal rule for making money in the equity markets i.e “buy low and sell high”.

The average retail investor always thinks that there is some magic stock or fund scheme out there that will make him rich and all he has to do is identify it. In this search for ambrosia, what happens is that he gets sold on all the latest investment schemes and stock tips by the financial advisors, agents or brokers, especially when the market is at its peak. To stay away from this booby trap, the question that one needs to ask is NOT ‘what to buy?’ BUT ‘when to buy?’

The secret to profitable investment is to ‘Pay Less’

A simple rule for deciding when to invest in the stock market can be developed based on the ‘Price-to-Earnings Ratio’ or ‘P/E Ratio’ of the Index. But before going into the P/E of the Index, let me first explain how to calculate the P/E of an individual company.

P/E of a company = Share price of the company/ Earnings per share

where, the Earnings per share = Net Profit made by the company during the previous year/ Total number of shares in the company

The Index is nothing but a weighted average of the share prices of underlying companies. The National Stock Exchange’s ‘Nifty Index’ represents 50 of the largest companies listed on the Stock Exchange, spread across sectors. Similarly, the Bombay Stock Exchange’s ‘Sensex’ is a collection of 30 of the largest listed companies in India. The Index can be taken as a representative of the entire stock market. This is why when the Index is down, most probably your portfolio of stocks is also down.

The P/E ratio of the Index compares the share price of all the underlying companies to the annual profit (earnings) of these companies. Whenever the share prices change, the P/E ratio also changes. Let me give you an example: In Jan 2008, the P/E ratio of the Nifty Index was 28. Arithmetically, P/E= 28 or after cross-multiplying P=28*E. i.e the share price of the underlying companies was 28 times the annual profit (earnings) made by the companies (per share). In other words, you had to pay 28 years’ profit upfront to buy their shares (without considering growth in profit). Doesn’t that sound terribly expensive? You bet! Especially if I were to tell you that today, the same companies are available at a P/E of 12.

As you would have guessed by now, the power of the P/E ratio (of the Index) is that it acts as an indicator of how expensive (overpriced) or how cheap (under priced) the market is. A logical extension of this is to set a lower limit for the P/E ratio, below which you can invest in the stock market and an upper limit, above which you can start selling your holdings.
Below is a graph of the P/E ratio of the Nifty Index plotted over the last 10 years. What comes out clearly is that the tops are attained above a P/E ratio of 25 while the bottoms are attained below a P/E ratio of 15. By investing in the stock market when the P/E is below 15 (Bottom Band) and liquidating your investments when the P/E is above 25 (Top Band) you would have not only protected your wealth but also reaped above average return on your investment.

Disclaimer - Hindsight is always 20/20 and future performance may not reflect the past. But hey! This simple technique will at least help you stay away from the trap of “buying high and selling low”

You can check the daily P/E ratio for the Index on www.nseindia.com (Trail: Home page > Indices > Statistics). Next fortnight, I’ll discuss a simple investment instrument through which you can make best use of the above technique and reap safe long-term gains from the stock market.

Let me leave you with a closing quote: “Be greedy when others are fearful, be fearful when others are greedy” (Warren Buffett)