Tuesday, July 20, 2010

The Intelligent Investor (or How to at least sound like one !)

Basic things which will be helpful while reading a business paper.Though its lifted straight from AMC website thought it will be useful to share it here.

I.    India is expensive; Investors reconsider fresh investments
II.   Inflation figures spook market
III.  Advance tax numbers indicate robust quarterly corporate earnings
IV.  Liquidity is tight
V.  Market is currently overbought
VI.  Risk weight age on these assets is 150per cent
VII. Market in a bear hug
VIII. There was some unwinding of long positions in the futures market

I. India is expensive; Investors reconsider fresh investments;  Valuations look attractive

Lesson 101 of Valuation comprises 4 words really - Buy Low, Sell High. Words we hear often and from people who seem unconnected to the stock markets - your grandma, the local grocer or even your family jeweler. Yet, behind this seemingly simple line, resides a very complex world. How do we know what is low, what is high and how do we measure it? The terms 'Low' and 'High' are relative terms - which means that for their value to be understood they need to be compared to something. But for that we need a common parameter of comparison. This is where P/E comes into the picture.

P/E ratios are typically used as a first-cut measure by investors to determine if a stock is overvalued or underpriced and whether it makes sense to invest in it. The P/E ratio or Price Earnings Multiple is calculated by dividing the price (of a share) by its earnings (EPS or earnings per share). It means that for a given level of performance by the company - EPS, the market has priced the stock at a particular level - P.

Take for instance a company, Xlerate, in the biotech space. Say, the company's stock price is Rs 240 and its EPS forecast for the year is Rs 8, then the PE for Xlerate is 30. However 30 per se means nothing; it doesn't signify if the P/E is high or low and whether one should buy Xlerate stock.
To take that decision, one needs to compare the P/E to other stocks in a comparable category or industry. So if most other stocks in the biotech industry have P/Es of around 40, then Xlerate could be undervalued - given its P/E is 30 and lower than the industry average, and hence its 'valuation seems attractive'
However there could be two reasons why the market has priced it lower than the rest of the companies in its category: Either the major local and global investors are unaware of the company and its performance and hence haven't been able to value it correctly, or they think the stock purposely ought to be priced lower than competitors due to reasons like bad management, expected slowdown in performance, inadequate ability to deal with future/competition, etc.
Similar to a stock, foreign institutional investors who have allocations for various countries also compare India (the major indices - Sensex and Nifty) to that of other emerging markets.
If most of the other emerging market indices P/E s are at around 12 and India's P/E is at 17, then India is considered 'expensive'
Hence P/Es of companies or countries should be compared to their industry/category average to understand if they are cheap and hence attractive, or overvalued and hence expensive.

II. Inflation figures spook market

When it comes to complaining about rising vegetable prices, we are in good company - even the Prime Minister's wife does it. That is not however the reason why the Reserve Bank of India aggressively monitors inflation. Inflation is basically a measure of prices in the country. It is measured by something called the WPI - wholesale price index, which factors in prices of basic goods and commodities in India. It is usually indicated in percentage terms. So if the WPI is 5.6%, then it means that wholesale prices have risen by 5.6% over the same date last year. But even if inflation sounds like yet another burden that common people have to deal with, for the banking and financial system players, inflation is the centre of their universe. The reason: inflation erodes the value of money and hence the return on investment. If inflation is 4%, it means that a lunch costing Rs 100 last year will cost your Rs 104 today. Hence your Rs 100 should have grown by Rs 4 in one year for you to enjoy the same standard of living. Hence for you to have a 'real' return on your investment of Rs 100, the interest rate should be more than 4%.

Hence when inflation rises, interest rates need to rise to ensure that investors get 'real returns'.

Rising interest rates means:

• the cost of loans for both companies and individuals increase

• falling asset prices thereby reducing the value of individual and corporate assets - be it land, homes, shares,
   bonds, gold - almost immediately Hence rising inflation numbers tend to scare off investors in bonds and shares
   since the value of their portfolio declines

III. Advance tax numbers indicate robust quarterly corporate earnings

Think of it as the old gypsy woman reading tea leaves to predict your future except that advance tax payments are a far more reliable tool of estimating the state of the country's corporate performance. Companies pay tax in four installments during the year. The four deadlines are the 15th of June, September, December and March. The tax paid in the first three installments is referred to as advance tax. Since companies pay tax on the profits they make, higher tax payments indicate that the company is performing well and on its way to recording higher profits. Hence advance tax payments indicate all is well with the corporate world. Typically market observers track advance tax payment this year vis-a-vis the last and if it registers a rise, it indicates that companies are going to post better results this year.

IV. Liquidity is tight

A favourite of the pink papers, this phrase is used generously by journalists across the stock, debt and commodities markets. Liquidity refers to amount of money floating in the system and which is available to corporates, government and individuals. The country's central bank, the Reserve Bank of India creates money in the system. It also reduces the amount of money in circulation by sucking up money from the system either by buying rupees from banks and selling them foreign currency, or by issuing government securities which banks and institutions subscribe to. The RBI is therefore the controller of liquidity. Liquidity can become 'tight' when there the demand for funds far exceeds the supply. This could happen due to a variety of reasons:

   1. Corporates are borrowing more to fund their business growth and for capital investments
   2. The Government of India is borrowing more to cover the gap between its expenses and income
   3. The value of the rupee is depreciating faster that the RBI would like and hence the RBI is 'buying rupees' to increase its value versus the dollar.

And the usual repercussion of tight liquidity is increasing interest rates

V. Market is currently overbought

How many times have we read the business papers and thought: Did all the players in the stock markets bunk English classes in school? Why else would they use words like overbought or oversold? Then it dawns on us; these are technical terms and we don't really understand them. It's not their English; it's our financial market knowledge that's at fault.

Simply put, the market being overbought means that the market has risen too much or too fast and is 'expensive' (refer issue #5 for understanding valuations). Likewise, oversold means that the prices have fallen too sharply.

The terms per se are used by technical analysts - analysts who chart price movements to predict what the future price of the stock is likely to be. Usually there is a fair degree of balance between buyers and sellers in the market. However sometimes certain imbalances are triggered and there might be too much buying or too much selling. These are unnatural conditions and often an indicator that one must take the contrary action. Hence if the market is considered overbought, the technical analyst will sell, and if the market is considered oversold, she will buy.

VI. Risk weight age on these assets is 150per cent

Risk is key to all investments. Banks are required by law to maintain a particular level of capital to ensure that if the bank's assets or loans go sour, there is enough capital to back it up and depositors' monies are protected. This level is called the Capital Adequacy Ratio (CAR) and the Reserve Bank of India (RBI) has set it currently at nine per cent of risk weighted assets for all commercial banks; which means that if the bank lends Rs 100, it has to maintain Rs 9 as capital.
Apparently, one jargon leads us to another. It definitely is the maze we've all come to expect of the world of investments and finance. First it was CAR and now Risk Weightage. So what does risk weightage mean?

The loans or investments a bank makes all carry a particular level of risk - the risk of default. RBI requires that banks classify their assets (loans and investments) according to the risk they carry.
So typically government securities carry zero default risk since they are backed by the government. Hence the risk weightage assigned them is zero. So technically if a bank had invested all its money in government bonds, it would not be required to maintain any capital since there is no risk. If a bank lends to corporates, then those loans need to carry 100 per cent weightage. So the bank will maintain 9 per cent of the value of the loan as capital. If risk weightage on assets is 150 per cent, then banks are required to maintain Rs 13.5 of the value of the loan/investment - calculated as 150 per cent of 9.

Banks which have low capital (equity and reserves) prefer to invest a significant portion of their money in gilts since any investments in risk weighted assets means that they would have to raise more money as capital to back up those assets.

VII. Market in a bear hug

Bears represent market players who keep prices down while a bullish market represents rising prices. This is easier to visualize and understand from a popular myth which says that the terms are derived from the way the animals attack a foe - bears attack by swiping their paws downward and bulls toss their horns upward. Though the imagery helps in understanding the terms, it is but mere myth.
According to the The Wall Street Journal Guide to Understanding Money and Markets, the story behind the terminology of Bears and Bulls is as follows:
'Bear skin jobbers' were known for selling bear skins that they did not own; i.e., the bears had not yet been caught. This was the original source of the term "bear." This term eventually was used to describe short sellers, speculators who sold shares that they did not own, bought after a price drop, and then delivered the shares. Because bull and bear baiting were once popular sports, "bulls" was understood as the opposite of "bears." i.e., the bulls were those people who bought in the expectation that a stock price would rise, not fall.
Hence if you read the markets are in a bear hug, you can be sure that your stocks are not going to be moving up in a hurry.

VIII. There was some unwinding of long positions in the futures market....

This statement contains far too much jargon for even us those of us with above average IQ, but no one said that the world of investment was anywhere close to being easy. It's probably easier to learn two foreign languages simultaneously than decipher finance's complexity. So baby steps on this one:
Futures market
This market refers to contracts where the buyer and seller agree to transact at a future date; the price and quantity for that future transaction is however fixed in the present. Think of a futures contract as an understanding you would get into with your local raddiwallah. You promise the raddiwallah that you will give him 5 kilos of newspapers every month over the next six months. The raddiwallah in turn promises to pay you Rs 5 per kilo. So basically the two of you'll have entered into a futures contract where the price and quantity has been pre-fixed regardless of what the price of second-hand newspapers will be in the coming months. Both the parties benefit: The raddiwallah is locking in a guaranteed supply of newspapers, whereas you are guaranteed you will get a good price for the next 6 months.

Similar such transactions take place in the stocks and commodities markets. People tend to enter into futures contracts if they think the markets will be volatile in the future. By agreeing to price and quantity now, they can control their risk.

Long positions: When an investor holds a long position, it means that he actually holds the share and intends to hold it for a while because he thinks prices will go up on the share. If prices go down, then the investor loses money. Similarly, a long position in a futures contract, means the person is required to buy the share at the future date. She will make money if the share price goes up at a later date.

Unwinding: This refers to the process of selling to liquidate long positions

Hence this apparently Greek sounding line 'There was some unwinding of long positions in the futures market' basically means that investors think the market is likely to go down in the future and hence are selling their underlying shares and offloading their long positions.

link for AMC

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