Investing Fundamentals

*FIRST PRIORITY SHOULD BE TO ENSURE ADEQUATE LIQUIDITY

MAKE SHORT TERM INVESTMENTS TO MAINTAIN LIQUIDITY AND EARN SOME RETURNS

AVOID UNUSUALLY HIGH RETURN INVESTMENTS-IT MAY BE RISKY

Stock investors-Institutional investors- portfolio managersIndividual investors- day tradersReturn from investing in stock-DividendsPrice appreciation also called capital appreciation or capital gain

* Growth Stocks Vs Income Stocks#Income stocks- generally older, established firms that have less chance for substantial growth and less variable earningsL&T, BHEL, Axis bank, SBI, Infosys etcThe income companies believe in declaration of high dividends.#Growth stocks- generally younger firms that have more growth opportunities and more variable earningsIndraprastha gas, Biocon, Nilkamal, Mindtree etc.The growth companies give low dividends

BondsReturn from investing in bonds is in the form of coupon payments and price appreciation

Mutual FundsReturn from investing in mutual funds comes from coupon or dividend payments generated by the portfolio of the fundReal estateBuying a home or purchasing rental property or landReturn from investing in real estate comes in the form of rent payments and selling the property for a higher price than paid for it

INVESTMENT RETURN AND RISKMeasuring the return on your investment

Total return = Cash payment received + price change over the periodPurchase price of the asset

INVESTMENT RETURN AND RISK (CONTD)Example: If you pay $1,000 to make an investment and receive $1,100 when you sell the investment in one year, you earn a return of:R =

DIFFERING TAX RATES ON RETURNSIncome received as interest payment is classified as ordinary incomeThe income from sale of investments is called capital gainlong term capital gain (LTCG)-Capital gains resulting from sale of investments held more than one year in case of- shares and equity MFs.held for more than three years in case of- property, land, gold, shares sold off market etc.

Short term capital gain (STCG)- if held for shorter durations as in the above cases.*

Differing tax rates on returnsShare dividends are not taxable in India.STCG from investments in stocks (if levied STT) are taxed at 15%LTCG from sale of stocks (if levied STT) are not taxable.CAPITAL ASSETSSTCG from sale of capital assets are taxed as ordinary income.LTCG from sale of capital assets are taxed at 10% without indexation (Sale cost), or 20% with indexation (Sale Indexed cost), whichever is lower.(LTCG = sale price indexed cost of acquisition) Indexed Cost of Acquisition or inflated cost = Actual Purchase Price * (Cost Inflation index during the year of sale / Cost Inflation Index during the year of purchase)

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Let us try to understand this with a simple example.

An asset was purchased in FY 1996-97 for Rs. 2.50 lacs. This asset was sold in FY 2014-15 for Rs. 8.50 lacs. Cost Inflation Index in 1996-97 was 305 and in 2014-15 it is 1024

So, indexed cost of acquisition: Rs. 2,50,000 * (1024/305) = Rs. 8,39,344

Long Term Capital Gains would be calculated as :

With Indexation: Capital Gain= Selling Price of an asset Indexed Cost i.e. Rs. 850000 Rs. 839344 = Rs. 10656. Therefore tax payable will be 20% of Rs. 10656 which comes to Rs. 2131.

Without indexation: The Capital Gains = Selling Price of an asset Cost of acquisition i.e. Rs. 850000 Rs. 250000 = Capital Gains is Rs. 600,000. Therefore tax payable @ 10% of Rs. 600000 would have come to Rs. 60,000.So you save Rs. 57,869 in taxes by using the benefit of indexation.

INVESTMENT RETURN AND RISK (CONTD)Risk from investingReturns are uncertainFuture values of investments are dependent on demand by investorsBefore you select an investment, you should assess the risk

Measuring an investments riskAll stocks are subject to two forms of risk Systematic risk is the risk that all publicly traded equities share due to market-wide movements.Wall Street proverb a rising tide raises all boatsNon-systematic risk is based on the earnings strength of the underlying company of your stock, and not the overall market.Non-systematic risk is generally more manageable than systematic risk for the individual investor. The traditional way of offsetting non-systematic risk is diversification across different sectors and asset classes

*1. Range of returns: returns of a specific investment over a given period(range = highest return lowest return)

2. Standard deviation: standard deviation of stocks monthly returns. It measures the degree of volatility in the stocks return over timeA risky stock will normally have a relatively wide range of returns and a high standard deviation of returnsThere are other subjective measures of riskMeasures of Risk

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3. Beta

Beta measures nondiversifiable risk i.e. Systematic risk.

Beta calculation is performed using a statistical technique called Regression analysis.

The whole market is assigned a beta of 1.

Stocks that have a beta greater than 1 have greater price volatility than the overall market and are considered to have greater risk.

Stocks with a beta of 1 move up and down with the market.

Stocks with a beta less than 1 have less price volatility than the market as a whole and are considered to have less risk.

Risk relates to return. Investors normally expect that stocks with a higher beta should command a risk premium, that is provide a higher return than the market. More risk should mean more reward!

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Beta for one year period November 2012 October 2013

CompanyBetaLARSEN & TOU1.3MAHINDRA & M0.92TATA MOTORS1.56HIND UNI LT0.33I T C LTD0.52STERLITE IN1.66WIPRO LTD.0.75SUN PHARMACE0.52GAIL INDIA0.52ICICI BANK L1.54JINDAL STEEL1.46BHARTI ARTL0.87MARUTISUZUK0.7TCS LTD.0.88NTPC LTD0.77BAJAJ AUTO0.65COAL INDIA0.64SENSEX1

CompanyBeta ValuesHOUSING DEVELOPMENT FINANCE CORP.LTD.1.3CIPLA LTD.0.59BHARAT HEAVY ELECTRICALS LTD.1.42STATE BANK OF INDIA1.13DR.REDDY'S LABORATORIES LTD.0.56HDFC BANK LTD.1.2HERO MOTOCORP LTD.0.67INFOSYS LTD.0.58Sesa Sterlite Limited1.32OIL AND NATURAL GAS CORPORATION LTD.1.24RELIANCE INDUSTRIES LTD.1.11TATA POWER CO.LTD.1.01HINDALCO INDUSTRIES LTD.1.32

*Using Beta to Estimate ReturnsCapital Asset Pricing Model-

Rs = Rf + Bs(Rm-Rf)Where:Rs = the required return on investmentRf = risk-free rate of returnRm = the average return on all stocksBs = the stocks beta

It is easy to see that Rs increases with increase in its beta.

*Assume a security with a beta of 1.2 is being considered at a time when the risk-free rate is 4 percent and the market return is expected to be 12 percent.

Rs = 4% + (1.2 * (12% - 4%)) = 4% + (1.2 * 8%) = 4% + 9.6% = 13.6%

The investor should therefore require 13.6% return on this investment as compensation for systematic risk assumed , given the stocks beta of 1.2.

TRADEOFF BETWEEN RETURN AND RISKReturn-risk tradeoff among stocksSmall firms tend to have more growth potential, but higher riskIPOs may offer high returns, but also have high risk, especially for individual investorsReturn-risk tradeoff among bondsLarge, well-known firms have low return, low riskHigh risk bonds offer higher payments

LEARNING FROM THE INVESTMENT MISTAKES OF OTHERSMaking decisions based on unrealistic goalsBorrowing to investTaking risks to recover losses from previous investmentsFocus on Ethics: Falling prey to online investment fraudAvoid making decisions without facts

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