Saturday, July 5, 2008

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

The road to upward mobility is best traveled by name-droppers. While
Page Three parties might be the epitome of air-kissing and social name
dropping, the corporate world has its own special version. It's called
Jargon Spewing. The more jargon you throw at colleagues, bosses,
vendors, the more likely people will regard you as intelligent and
well read and in-the-know.

So if you want to impress that snooty colleague in the next cubicle
with a few well-chosen technical terms, make sense of all the jargon
splashed across the pink papers, or most importantly, avoid having the
blank I'm-too-dumb-to-write-my-own name kind of stare on your face
when people around make complex-sounding statements at you, here's a
primer:

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

That's a fair bit of jargon for anyone wanting to impress others.
However if you are surrounded by the not-easy-to-impress types, you
can atleast console yourself that reading the business papers now
seems a far less formidable task than before. Happy reading.

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 - 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:

Corporates are borrowing more to fund their business growth and for
capital investments
The Government of India is borrowing more to cover the gap between its
expenses and income
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 visualise 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.

Source: www.indian-mutualfund.blogspot.com

--
Warm Regards

Aditya NADIG :)

http://nadigonline.blogspot.com


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