WHAT ARE SHARES?
Capital market investments are of different kinds. Each investment has certain features, provides specific benefits and serves specific purposes. One of the common ways of making an investment is through purchase of shares in a company. Shares are a mode of holding ownership in a company. Holding shares means becoming a part owner of a company. One can enjoy all the benefits that come with ownership keeping in mind the consequent risks.
In common parlance, investment activities are referred to as buying of shares and those who hold the shares are known as shareholders. Alternatively, it is also known as buying equity in a company and shareholders are also known as equity holders or equity shareholders. Shares are also known as scripts traded on the stock exchange.
DEALING IN SHARES
The term shares are used in relation with a company and there are two ways in which the shares are usually purchased and sold. There are companies, which are listed on a stock exchange. Shares of such companies can be bought and sold on the exchange. An investor can buy or sell the shares by undertaking a trade on the stock exchange through a broker. When the shares are not traded on the exchange, they are bought either from an existing shareholder or directly from the company.
A company is said to make an initial public offer, when it is making an issue of new shares to the public for the first time. Subsequent issues are known as follow on public offers. The shares offered can either be newly issued shares or shares of the existing holders that are being offered to the public.
Shares are instruments through which companies raise funds from a large number of investors spread across the world. Since the capital requirement of several businesses is quite large, it is not possible for a small number of people to raise this kind of capital. It makes good sense, therefore, to have a corporate structure where a large number of people get together and pool their money through the purchase of shares.
Buying shares in listed public limited companies is a good option because the number of members is more than 50 and there is no restriction on the selling of the shares. So, the investor can buy a holding in the company to earn some returns and sell it off when they feel they are getting a good price or they want to switch their investment to a better option.
Shares entitle a person to earn a dividend from the company. They also carry a risk in that if the company winds up business, the shareholders will be the last ones to get their money. This means equity shareholders will be paid only when there is some money left after all the outsiders like creditors have been paid their dues. Thus, it is possible that there might not be anything left for the equity shareholders when the distribution of the assets takes place.
The liability of the shareholder is limited in the sense that he is required to pay only the amount of the value of shares. The company cannot, under any circumstances, ask the shareholder to pay any sum in excess of this amount for any reason.
Overall, the highest risk in the investment is for the equity shareholders because there might not be any sum coming back to the shareholder when the company shuts its business. In terms of day-to-day investment, the risk is seen differently as it might happen that the value of the equity shares on a stock exchange will fall after a person has purchased it leading to a loss when this is sold. This might result in the investor actually earning negative returns from the investment. The upside is that the gains can be huge resulting in the value of the investment rising quite sharply in a short period.
TYPES OF SHARES
Equity shares are referred to simply as ‘shares’ in common parlance. Across the world, there are shares with different features. One has to be sure of the exact kind of shares that one is referring to. Clarity in this matter will help as a minor change in the name can alter the nature and scope of the investment for investors.
FOREIGN FEATURE
There are various types of shares in the foreign context. One of them is worth a mention here. As an exception to the rule of ‘1 vote for 1 share’, some shares have proportionately higher voting rights. Accordingly, each share could have 5 or 10 votes each. This would enable an investor to control the business by holding only a small part of the equity capital.
INDIAN SCENARIO
Indian investors have two types of shares to choose from. One might be familiar with equity shares as such shares of listed companies are traded in the market.
These shares are entitled to a dividend each year depending on the performance of the company. It is possible that a company does not declare dividend for several years, especially when it’s making losses. Even if there is a profit, it is the prerogative of the management to declare dividend. If they feel that and the money would be put to better use within the business then they can recommend that there is no dividend to be paid that year. Thus, equity shares are a high- risk investment for the investor.
On the other hand, Preference shares are less risky since the dividend is fixed. The holders of these shares are given preference in payment of dividend as well the payout over the equity shareholders hence, the name preference shares. Preference shares have to be redeemed within a specified period of time and hence the investors here would be entitled to a fixed dividend each year for the time they are in existence. The rate of dividend is mentioned on the shares so one knows what they will get by investing in these shares.
Preference shares can be classified into several kinds based on their features. Redeemable preference shares, as the name suggests, have to be redeemed after a certain time period.
Dividend on cumulative preference shares is carried forward to the next year, if not paid in the current year for any reason. They are paid at a later date when the required sum is available for payment. Convertible preference shares are converted after a specific point of time into some other instrument.
SHARES IN A BALANCE SHEET
While discussing the type of shares, it is important to see how they actually operate in the real world. Pick up any annual report and you will see that there are several terms that are mentioned with the shares. Here is an explanation of what each of them means.
Shares will come on the liability side of the balance sheet. It is on the liability side because this amount belongs to the shareholders of the company. If and when the company is wound up the company is liable to pay it back to the owners.
This figure does not give rise to an income or an expense and hence it does not appear in the profit and loss account but is seen in the balance sheet. After that within the head liabilities, there is a sub head called share capital. This is the head, which shows the total share capital raised by the company.
The first item that an investor will come across in the balance sheet related to shares is the ‘Authorised Share Capital’. To understand this figure one has to go back to the fundamental documents of a company, the memorandum of association and the articles of association. The former deals with the relation of the company with respect to outsiders while the latter deals with the way in which a company will conduct its operations internally.
The Memorandum has the details about the registered office of the company, the objects of the company as well as the share capital of the company. The authorised capital figure is the maximum amount that can be raised by a company through the issue of shares. Additional shares cannot be issued if the limit is exhausted till the authorised share capital figure is amended.
Another important point to note is the face value of the shares. There are several values that the share can take like Rs 10, Rs 5, Rs 2 and even Re 1. Then comes the issued share capital. This is the actual number of shares that have been issued by a company. The difference between the authorised share capital and the issued share capital will give an idea about the additional shares that can be issued in case there is a need to do so without having to change the Memorandum.
In most cases, the issued share capital is less because the companies do not usually exhaust the entire limit and only a proportion of it has been used. In these figures the figure of the previous year will also be present in brackets in the balance sheet and this will give an idea about the change over the year.
Subscribed capital is that part of the issued shares that are taken up or subscribed by the investors. When all the shares that are issued are taken up by the investors then the issued and the subscribed capital will be same. This will give an idea of the actual number of shares that are in circulation as they have been issued and taken up by the investors.
The final figure on the share capital side is the paid up share capital. This represents the part of the share capital that has been paid up out of the shares that have been subscribed. Shares can be issued in such a way that several payments have to be made for the full amount of the investment. This happens as the company calls up money in several instalments depending upon the need for funds.
This means that out of say a face value of Rs 10, the amount called at the time of application of the shares might be just Rs 5 with the remaining Rs 5 to be paid at the time of allotment of the shares. If there are investors who do not pay up the required amount at the time of the allotment of the shares then the paid up value will differ from the subscribed value.
By looking at the paid up figure along with the called up figure it will give an indication to the extent of the share capital that has been asked for but not paid up. ‘Called up’ means that the amount that has been demanded from the public or the investors. It might so happen that the amount of the share capital has not been called up only which will mean that it will also not be paid up. There will be a difference between the called up capital and the paid up capital when some investors do not pay the amount demanded.
BONUS AND RIGHTS SHARES
The balance sheet will show the extent of bonus shares issued by the company. This will give a good idea about the composition of the share capital as to how much of it has been paid for and how much has been received free of cost.
Bonus shares are given free to the shareholders. This is done by transferring amounts from the reserves of the company to the share capital. In effect, the investor’s capital increases without the need to bring in any additional amount. Bonus shares are given in a specific ratio, like say 1: 1. This means one bonus share will be issued for every share held. So, someone is holding 100 shares in a company will find his holding double to 200 shares after the bonus issue.
While this might look like a great giveaway in terms of immediate price impact there is not much that the investor will witness. This is because the share price in the market will correct for the bonus shares issued when they come in the market. For example if the price of the share of a company was around Rs 500 and it issues a bonus of 1:1 then the price of the share on the ex bonus date will be around Rs 250 adjusting for the issue of the shares. There can be a sharp rise or fall in price when the bonus announcement is made as investors absorb this factor into their calculations about the future growth of the company. This is different from the adjustment impact seen when the new shares are factored into the overall share price.
Two terms would be important for the investors at this stage and these are ‘ex’ and ‘cum’. The terms put before various types of shares and prices gives an indication of what the prices contains and what it excludes. For example, if the quotation for a given price is that it is ex-bonus, the share price excludes the impact of the bonus that has been announced by the company.
On the other hand, the term cum-bonus means that the share price includes the benefit of the bonus. This means that investors, who buy the share on cum-bonus price, will get the benefit of the bonus. When the price of the share goes ex-bonus, then the bonus issue is excluded for investors buying the shares. So, this will reflect the new situation and the valuation will be based on the conditions prevailing after the proposed issue of bonus is put through.
A rights issue is an offering to the existing shareholders of the company in a certain proportion based on the existing holdings. This means that when a company wants to raise additional capital then instead of asking new investors to put money it prefers to tap the existing shareholders. Usually, the price is at a discount to the current market price for the benefit of the existing shareholders. A ratio is decided for the number of shares that a person will be entitled to and the issue is then usually open for around a month in the market.
The shareholders also have the option of buying more shares than offered if some part of the issue remains unsubscribed by other investors. Thus, rights issue is an opportunity for the shareholders to increase their holdings in the company.
BENEFITS OF HOLDING SHARES
There are several benefits for investors holding equity shares. Gaining from the price rise in the shares and booking big capital gains are obvious benefits. In fact, these are reasons enough for most people to invest. There are, however, other benefits that comes along which must also be considered in deciding the process of investment.
OWNERSHIP OF THE COMPANY
The biggest non-monetary gain for equity shareholders is that they become owners of the company. This means that any decision in the company is taken with the consideration of the equity shareholders and their permission is required. To the extent of their holdings, investors become part owners in the company. In most cases, shares usher on investors a right to vote, which is in direct proportion to their holdings, at the company’s meetings.
Voting and other ownership rights can be restricted in some companies by special act or rules for investments. Holding shares and becoming an owner can give a sense of pride and good feeling for people who might not have the required funds to run their own company. The term ownership is notional because this does not mean that a person who holds say 100 shares in a company will go to the company’s office and then start running the business. They have a limited power but can still call themselves part owners of the business.
INFORMATION ADVANTAGE
There is the advantage of getting all the information with regard to the happenings in the company when one is the owner of shares in the company. The company functions in a certain manner and there is a process to be followed for each step of the action.
The shareholders do not manage the day–to-day activities of the company. This job is left to the professionals. However, there is a need for the shareholders to be informed about the decisions taken with respect to the company and their permission or consent has to be taken in several cases. They have to be informed of the various developments that are taking place in the company.
The process of information is fulfilled by the submission of various details about the steps to be undertaken by the company. This means that in case there is some development in the company regarding restructuring then the details of the move will have to be sent to the shareholders. Periodic reports and other information generating details would also have to be sent to the shareholders to enable them make informed decisions.
RIGHT TO DIVIDEND
One of the rights of an investor is to receive the dividends declared by a company. Dividend is the earning of the company that is paid out to the shareholders and is declared as a percentage figure of the face value of the share.
An investor has the right to receive the amount if he is a holder of those particular shares on the record date fixed by the company. Only those people, who are shareholders of the company as on the record date, will be entitled to receive the dividend.
Dividend is the payment to the shareholders out of the profit of the company after providing for the various requirements and transfers. This is declared as a certain percentage of the face value of the share and is declared and paid at various times of the year. There are dividends declared on a quarterly basis by companies while some companies do it on a half yearly basis. Several others prefer to pay out dividends only on an annual basis.
ATTEND GENERAL MEETINGS
The general meetings are the meetings of the shareholders of the company. Here each shareholder has the right to participate in the proceedings of the meeting. There are several items that are discussed in these meetings and then there is also voting on these issues.
Regulations have earmarked several businesses mandatory to be conducted in general meeting. A shareholder can speak on the issues on hand and at the same time also exercise his other rights at the meeting. One has to remember that the power welded by a person in the meeting will be proportionate to the shares that he holds in the company.
The general meetings are either annual general meetings or extraordinary general meetings. Shareholders can refuse to approve proposals for want of relevant information and explanation. Companies are bound to give such information even if it means delaying the implementation of an important project or so on.
VOTING RIGHTS
Companies face various issues throughout the year. Some of these issues require the approval of members. In case there is no consensus, such approvals have to be decided through voting. Thus shareholders take a part in the actual decision making in a company.
However, many cases investors must realise they might not be able to influence the decision because their holdings will be quite small. They have to live by the decision of the majority even though they may hold a different vie point on a particular subject.
The shareholder must exercise voting rights very carefully. Though a single person cannot influence decisions made, a large number of them present together can be a significant influence on the way in which the issue is dealt with.
Matters can go out of hand in some situations. This can happen when there is some controversial issue at play. The house may be divided in the middle and hence every vote counts. In such a situation, the vote of the member becomes very important and it has tremendous value.
ADDITIONAL SHARE HOLDINGS
Companies often reward their shareholders through additional shareholdings. Under the rights issue, a company is supposed to make an offer for shares to the existing shareholders and if they refuse then it can be offered to outsiders. Rights shares are beneficial because usually they are offered at a slightly lower than the market price. This provides the benefit of gaining from the investments and also participating in the growth of the company.
There is also the issue of bonus shares where the existing shareholders are offered additional shares in a particular ratio for free. This is done by transferring the amount from the reserves of the company to the share capital account. Shareholders can benefit as the number of shares they hold will rise. The market price will correct to give impact to the shares.
RECEIVE SURPLUS ON LIQUIDATION
Being the owners of the company, equity shareholders are the last ones to be paid when the company goes into liquidation. This means if there are any assets left after all creditors are paid off, then these will be distributed among the equity holders.
In such a situation, the equity shareholders have the right to receive any surplus that remains after everyone else is paid off. This will be in return for the amount that they have invested as capital in the company.
Such situations are rare and happen only when companies cannot carry on business. Companies go for winding up, when there is no scope to increase shareholder value and this is the last alternative that will ensure some sort of payment.
FREE TRANSFERABILITY
Transferability is the ability to sell shares to someone who is willing to buy the shares at the decided price. There are no restrictions on the buying and selling of shares unless they fall under some specific head. For example, there is a lock-in of the shares issued to certain categories of people like promoters.
Thus, if you are an equity shareholder and you feel that the existing situation does not warrant remaining in your portfolio then you have the absolute right to sell your shares and get the available money for it.
POSTAL BALLOT
There is the new concept called postal ballot that has come into existence in the last few years. Here, the investor is sent postal ballots and they can vote on several issues related to the company without being physically present at the meeting. They can just send in their votes through the postal ballot and this will be counted.
The companies send across the issue on which the postal ballot is required along with an explanation of the reasons behind undertaking such a move. There is a ballot on which the voting can be made and then there is a self-addressed envelope with postage paid on it. All that an investor has to do is vote on the issue and then deposit this in the envelope and post it across. This has to reach the company before the due date for it to be counted as part of the overall tally.
TRADING IN SHARES
Trading is one of the fundamental factors that attract investors towards shares. The experience of investing in stock markets and changes that occur and the excitement generated are good enough reasons for people to be attracted to this mode of investment. Many believe that this area produces returns as well as a certain level of pleasure for the investors for being a part of the process.
STOCK EXCHANGES
One of the first things that have to be recorded is the idea of a stock exchange. A stock exchange is a medium through which there is trading in shares and securities. Earlier, the stock exchange was a physical space where the brokers used to gather and then deal in the shares face to face. There was a trading ring where the transactions used to take place.
Now, with the advent of information technology the stock exchange is a virtual place. Each member, who wishes to trade on the exchange, is connected by the trading terminal to a central place where all the buy and sell orders are matched and the transactions are effected. This means that a person sitting in Punjab can trade with a person sitting in Chennai by dealing through the terminals that are connected by satellite and other means of communication.
In the stock exchange, we now have an automated system of putting in order. All an investor does is to go through a broker and then put in their respective order at a given price or the available market price and then the system matches the best buy and the sell orders and the transaction is executed. Thus, for example an investor can go through his broker’s terminal and have an order of buying 100 Reliance shares at Rs 990. The system will look for the best quote that matches this requirement and will then execute the order.
There are two types of orders that the investor can give in the circumstances. The first is the limit order where the limit price for executing the order is given. Here, the price is specified above or below which the order will not be executed. For example, if there is a limit price of Rs 110 for buying 100 shares of NTPC then the shares will not be bought if the price stays above this level. On the other hand, in a market order, the order is executed at the prevailing market price in the stock and here the preference of the investor for a particular share price is not considered.
There are two main exchanges in the country namely the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) on which a large majority of the trading in the cash segment of the market takes place. Derivatives form the non-cash segment of the market, more on that later.
BUYING AND SELLING
The process of buying and selling of shares is called trading. While the process might look same for everyone, there is a lot of difference in the way trades are undertaken by different people.
The first major difference is the quantity. A small investor will go and buy say 50 or 100 shares of a particular company. The figure will rise for a high net worth individual (HNI) who has a larger capacity to buy shares. On the other hand, there are large investors called institutions buying lakhs of shares in a single transaction. Thus, there is a wide difference in the quantity of the shares that are bought and sold on the exchange.
Through dematerialisation, that has given rise to the concept of paperless trading, it is now possible for an individual to buy just 1 share in a company. In this system, the shares are not held in a physical form but are present in an electronic form in an account as an entry like one sees in the bank pass book.
The next part is the way in which the shares are bought. An investor who intends to buy and keep the shares will put in a buy order. When this is executed, the system will ensure that his shares are received in their demat account when the payout occurs. On the other hand, there are day traders who square off their position during the day. So, at the end of the day they do not have to receive or give any shares. They only have to receive or give the difference in the price of the shares that they have bought and sold.
For example, a person buys Reliance Industries say at Rs 998 in the morning and the sells the 100 shares in the afternoon for Rs 1,010. This person will not have to give or receive any shares but will get the difference in the price less the brokerage cost and other expenses that are payable to the broker and the regulators and the exchanges.
SETTLEMENT CYCLE
The settlement cycle is an important piece of the puzzle that has to be understood by the individual. The settlement cycle starts once the actual transaction takes place in terms of a buy or sell decision. This is then followed by a pay in/payout, which is on the second working day after the transaction. Here, the consideration for the purchase of shares is paid. At the same time, the shares should be transferred to the required account.
In case of a payout, the cash is paid out to the person selling the shares and the purchases will receiver the actual shares in the company. This will then complete the cycle. If a person is not able to pay in the shares on the due date then these will go for auction and then the person will have to pay the necessary price decided at the auction.
For example, if there is a share bought on Monday then the pay-in and payout of the amount will have to be on Wednesday. Accordingly, the investor has to ensure that the payment of money is immediate and then the shares will be received into the account at a later date. In addition, there will be a no-delivery period for both demat as well as physical settlement. This is a period when the specified shares will not attract delivery and they will have to be rolled over if one wants to take delivery.
THE SYSTEM
The orders are matched on the electronic system of the exchange. Hence, there is an element of transparency in the entire transaction. One knows the price at which the buyers are willing to pick up the shares and similarly one can also know the price at which the sellers are willing to sell the shares along with the quantity that each of them is willing to buy or sell. This gives a very clear idea about the situation in the market in terms of demand and supply equation.
The trades are settled with respect to a settlement cycle. A settlement cycle is a period where the net position is calculated and then the amount to be received or paid and the shares to be delivered are decided. Earlier, this process used to take one whole week in the Indian exchanges. Now, this has been brought down to one day.
This means that there is little time for an individual to react to the situation. If an investor does not want to have an open position at the end of the day, then he/she should square off the position by putting in an opposite trade by the end of the session in the day.
OTHER FACTORS
There are quite a few factors related to the valuation of shares that investors need to understand. These determine the actual price investors are able to get for their shares and gain or loss that they make with respect to the investment. The first thing is the face value of the share. It can be Re 1 or even Rs 5 or even Rs 10 depending on individual companies. The face value is the basic value of the share. However, the face value is only a value that is considered for academic purposes. The real value depends on the value of the company and hence this is the figure to be considered. The real value of a share can be either at a premium or a discount to the face value of the share. This premium or discount is decided by a host of market factors.
ONLINE SHARE TRADING AND TRADITIONAL WAY OF TRADING
There are different ways of trading in the stock exchange. However, the trading process follows a definite chain of events. This process consists of several parties and starts with the buyer who is connected to his broker who in turn linked with the exchange. Similarly, on the other side of the transaction there is the seller connected to the exchange through his broker. The stock exchange is where all of them come together. It is the place where the demand and the supply are matched and the deals are executed.
The method of trading in the stock market has undergone a sea change with the introduction of modern technology. There is also an element of convenience in the way in which the new system operates.
BENEFITS OF TRADING THROUGH THE EXCHANGE
The major benefit of trading through a stock exchange is the transparency that this brings to the entire process. The transaction is done in front of a screen at the best available price. Investors can see for themselves the prices that are being quoted in the market and the price that they will get for the quantity of shares that they wish to trade. Due to this, there is no reason why the individual would be cheated of the price that he should normally be able to get on the transaction.
The next thing is that there is adequate proof that a certain transaction has taken place. There is a complete record of the entire deal and hence tomorrow morning one of the parties cannot say that this transaction was not done with me and I will not honour my part of the bargain. There is an adequate back up measure to protect the various players involved in the form of margins and amounts that are required from the investors when they put through a transaction.
Another benefit that the individual will get is that there is a lower tax rate when the transaction is done on one of the major stock exchanges in the country that is recognized for the purpose. The rate of tax on long-term capital gains will be zero and that on short term capital gains will be 10% when the transaction is through a recognized stock exchange and securities transaction tax is paid on the amount.
CATEGORIES OF SHARES
The shares on the Bombay Stock Exchange are divided into various categories like A, B1, B2 etc that has its own meaning and interpretation. There are several points that are considered before a stock is allocated to a particular segment. In the midst of this, there are two important areas that play an important role in the demarcation.
The first is the market capitalisation of a company, which is the number of equity shares outstanding in a company multiplied by the market price. A high market cap shows that it has been valued in a certain manner by the market. The second factor is the trading volumes in a particular company seen on the exchange.
Both these factors together go on to determine the kind of position that a stock will have in terms of the group that it will fall under. The three groups of A, B1 and B2 generally has the stocks in the descending order on these points. Thus A group comprises of stocks that are large cap in nature and have a high trading volume. However, one has to remember that the classification of large cap and mid cap changes and varies quite drastically and hence there might be some difference on this point. B1 shares might be slightly less liquid and are mid cap in nature. However, it has to be remembered that a particular position might not hold at every point of time because changes in prices and the market situation can change the classification.
In addition, there are few other groups of shares in the market. The S group of shares is the small cap stocks with a low paid up capital (up to Rs 20 crore). These too are traded through the exchange. Many of them were earlier traded on the regional stock exchanges but have now been brought under this head. On the other hand, stocks with the mark T are those stocks that fall in the trade-to-trade segment. There has to be delivery for every transaction and a set off from opposite trades is not allowed on T stocks. Usually, companies that have witnessed lot of speculation or volatility are moved to this segment. This will ensure a cooling down of the speculation activity because delivery for any transaction will mean that an investor will put through a trade only when he has the ability to deliver the shares.
There is one more category called Z category of shares. Investors have to be very wary of this category. It comprises shares, which have not complied with various listing or the reporting requirements on the exchange. There is a high risk involved because the possibility of delisting, which may leave the investor high and dry, looms large.
There are several ways of putting through the trades on the stock exchange and one has to be aware of the route that one has adopted. This will determine the kind of risk that is associated with a particular way of trading.
MARKET SEGMENTS
The most important part of trading for a normal investor is through the cash segment. Whenever there is a purchase, the investor has to pay the required amount through the normal settlement cycle. This means that they have to get their own funding and complete the normal procedures for the purpose of the trade.
Under the margin system of trading, the broker allows the client to borrow money from him for the purpose of putting forward the trade. The figure of the margin will determine how much the investor will have to put in from his own pocket. Thus, for example if the margin is 70%, then the investor will invest 30% of the money from his side and the broker will fund the remaining 70%. This allows investors to take a position that is higher than what they would have been able to manage on their own.
Earlier, there was another concept called spot trading where the broker would purchase shares from clients and then pay them immediately but the price paid was a discount to the prevailing market price. This market was active because there was a very long settlement cycle due to which there was a premium on getting the cash immediately. The change in the settlement cycle through the shortening of the process has meant that this kind of market became obsolete.
THE TRADITIONAL WAY
In the traditional system of trading, the number of players was the same. There were two parties with the brokers as the middlemen. There was the investor on one side of the transaction and the broker on the other side of the transaction. The investor went and opened an account with the broker with whom he would trade. Whenever there was a need for a transaction the investor would call the broker on the phone and then put through the transaction after giving their account number.
Once the transaction was done the broker would prepare the contract note and the bill for the required amount. The investor would pay the amount to the broker through a cheque to meet the requirements of the pay-in of the system. On the other hand, when there was a sale, then the process for conducting the transaction was the same but the investor needed to ensure that the respective shares were transferred to the account of the broker before the payout date.
Here, the physical presence of the investor was required. The investor had to be present when the transaction took place and had to ensure that the various conditions were fulfilled. He also needed to ensure there were no bottlenecks and the process gets over smoothly.
Benefits of traditional way of trading
Direct contact between the broker and the investor
Additional information could be gathered from the broker
Flexible: small adjustments were possible
It could be done over the phone or even face to face
Easy way to trade
Simple process Problems
Physical presence of investor or his representative at the venue of trade
There is the possibility of some confusion when the transaction was being put through and this could play havoc with the situation
It does not offer any flexibility or convenience to the investor
Difficult to do for people who cannot have a high involvement in such efforts
ONLINE TRADING
The two players in the system remain the same, which are the investor and the broker. However, in online trading, though the broker is not visible as there is no name and face to the entity that role is taken over by the internet and the various systems in place on the website. Thus, the same functions as in a traditional route of trading take place but the method is different. The experience for the investor is completely different.
The investor is registered with the website of the broker. An online trading account is created in his name. Whenever there is a need to transact, either a purchase or a sale, the investor can log on to the particular website using their name and password and open their account. Once their account is opened they can go to the trading page and put in their respective transactions just the way they would have done this when they give the order to the broker on the phone. There is a facility for both market orders as well as limit orders. The system then accepts the transaction when the necessary password is given and executes it in the market. Once this is done the amount of the purchase is taken or put in the account of the individual depending upon the purchase or sale of the stocks. The shares are also delivered or taken from the demat account of the individual. Here, the individual does not have to undertake any part of this transaction and that is a relief because it frees them from the task of doing everything on their own.
Benefits of online trading
The investor can undertake transactions as per his convenience
No need of physical presence
No need to fill forms and follow procedures; processes are done automatically
It reduces the possibility of mistakes on the phone for the investor
Drawbacks of online trading
People not conversant with the internet and computers are at a disadvantage
Risk of account being hacked
High speed makes it difficult to detect and rectify mistakes
A lot of authority for the account is signed away by the investor to the brokerage without even knowing what they are. If not careful, the investor could be left holding all the losses.
MARKET TERMINOLOGY
Lot of terms and jargons are used in the equity markets and while some of the terms are not technical, they refer to specific things. This also makes for interesting knowledge for an individual, who is looking to understand the equity markets. Here are some of the terms and what they actually imply for an investor.
BULLS
This is one of the common terms used in the market to denote a person who is looking at the price of a share to rise. This person undertakes the activity of buying the shares at a lower price level and then selling them to others after this has risen to a higher level. They are known as the optimists in the market who expect the prices to rise. They are known as the bulls as they charge up the market on the upside. In many cases, bulls are at the forefront of raising the demand for a particular stock and then this will result in a price rise so that they are able to sell it off at a higher price. The outlook of this category of investors is positive.
BEARS
Bears have a different kind of viewpoint. For every buyer who purchases shares in the expectation of a rise in price there has to be a seller who is willing to sell the shares expecting a fall in the price of the share. The bears believe that the share prices will fall and hence they will sell off the shares at the current level and then buy them back at a lower level so that their aim is achieved. Bears are generally associated with a fall in prices and are hence regarded not very favourably by several investors. Investors need to know that they are just another category of investors just like them and they act on a certain view that they have regarding the market. There is no shorting possible in stocks on a long term basis except for intra day business in the cash segment however they can take a certain position in the futures and options market that will reflect their viewpoint. This enables them to gain if there is any fall in the market.
AMERICAN DEPOSITORY RECEIPTS/GLOBAL DEPOSITORY RECEIPTS
These are securities available in the foreign markets. While the ADRs are available in the US market or US exchanges, the GDRs are available in other foreign exchanges like Luxembourg. These instruments allow a foreign investor to buy shares in an Indian company without having to come to the Indian markets. They are created by a bank and they are proof of ownership of a specified number of shares of a foreign security that is held in a depository in the issuing company’s home country.
There is a specific ratio that is mentioned for the holding of the ADR/GDR. This is the number of shares that are available in lieu of the holding of a single ADR. The benefit for the holder is that the transfer and the settlement practices for the ADR/GDR is similar to what they would be undertaking for their own securities as this takes place on the foreign exchanges. Many foreign investors often prefer this route of investment because it’s easy to operate. It provides lower costs for transacting and the receipt of various benefits on the shares. For Indian companies too, this is a profitable route as they can get listed on the foreign exchanges and the holders of the receipt has the provision to convert their ADR/GDR into actual shares of the company
ANALYSTS
These are an integral part of the entire stock market setup and their role is increasing in prominence due to services they provide for their clients. This is usually a person who has expertise in evaluating the various financial investments. The key part of the job of this category of people is to perform research on the various investment options present and then make recommendations to institutions and investors to buy or sell securities. Analyst reports are considered very carefully in the market for the outlook and the message that it gives in terms of the decision regarding the stock. Analysts specialise in a particular sector or an industry. However, with the scope of the analysis increasing there is also a situation where the analysts are covering several sectors at the same time and they need to adapt to new responsibilities quickly.
EX AND CUM DATES
These are very important terms with respect to the various benefits that are available on the shares for an individual. The ex-date means that from a particular date the shares do not carry the value of the benefit that is being proposed. For example, if a share goes ex- bonus, the impact of the bonus shares have been removed from the share price and all the investors who buy the share after this period of time will not get the benefit of bonus and will accordingly pay the lower adjusted price for it.
Cum-price includes the specific benefit of a bonus, rights or dividend that is going to be given to the investor. As long as the price quoted in the market is cum-price the investor knows that the purchase of shares will have the benefits coming along for them.
VOLUMES
Volumes refer to the extent of trading in a particular share or group of shares. The higher the volume of trades, the greater is the liquidity in a particular stock. The volume in a particular company is considered in conjunction with the other indicators including price by technical analysts to predict the future movement of share prices.
Apart from the extent of interest in a particular stock, the volume will also give an indication of the way in which the free floating stock in the company is moving. There are certain holdings, which are with institutions and promoters, which are not available for buying and selling in the market. This means that the floating stock of a share is a certain figure and the extent to which this gets traded gives an indication of the way in which the trading trends are reflected in the market.
ARBITRAGE
Arbitrage refers to an opportunity between two investments that can be executed in a virtually risk-free manner. A very good example is the price of a share that is quoting differently on the two stock exchanges in the country. Here a person undertaking arbitrage activities may buy on the exchange that has a lower price and sell on the exchange that has a higher price. This might seem to be easy to do in theory but there are also some practical issues like providing delivery of the stock and managing the cash flow.
HEDGING
Hedging is a technique adopted by various investors to ensure that their risk in a particular trade is eliminated or reduced. This is undertaken by taking a completely opposite position in a second trade as compared to the position in the first one. This is made possible by the use of various derivative instruments like futures and options that are now available on the Indian markets.
A person may buy ITC shares in the cash market and sell it in the futures market. The transaction makes sure that a loss in one of the trades will lead to a gain in the other and this will balance out the situation for the investor. Usually, the exact matching is not possible and investors will find that there is also an additional cost for the hedging. Also, exact hedging might not be possible due to various restrictions in the market.
PENNY STOCKS
These are an essential part of any stock market across the world. Penny stocks are stocks that quote at a very low value, which is below their face value and are usually a few rupees. There is a lot of speculation that goes on in such stocks because a rise in their value means very high returns for the investor. However, there is also a very high risk in these shares because when times are bad, the volumes in these companies dry up and investors are not even able to retrieve the cost of these shares.
METHOD OF READING STOCK TABLES
A wide variety of financial information is available about stocks. A lot of this data is generated on a daily basis as the stocks get traded in the market. The investor must be able to read the stock tables in the right manner in order to do the necessary calculations and due diligence before investing.
One has to look out for several items while reading the various data present in the stock pages. The first thing to remember is that there is no fixed format in all publications even though most of the data is similar. There will be some variation, as each publication would like to distinguish the details that it has calculated and provided to its readers.
There are two price quotations that one will see which are of the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). All the stocks are not traded on both the exchanges and the number of stocks on the BSE is larger.
The first item that one sees is the BSE code for a company. There are two things that one needs to know here. The first is that the BSE has a unique code for every scrip that is traded on the exchange. One can get the necessary details about a company by referring to the BSE code.
This code is very important if you are tracking a particular company and want to find out the details that are available on the company. In case of smaller companies, brokers insist that you supply them with the BSE code so that the transaction can be executed without problems.
Name of the company will be given in the way it appears for the company at all places though in several cases it would have been shortened to initials or some other short form. The only thing that one has to be careful about is that there are often quotes for two exchanges BSE and NSE. So, one has to know which exchange has a specific quote and what is the figure on that particular exchange. In many cases, publications give both the quotes. But, some of them drop the quote of one of the exchanges to save space.
Prices are shown in five different figures. For the trading that has taken place during the day, there will be figures for open, high, low and close. The open refers to the opening price of the share during the day. The highest price that it was traded at during the day, the lowest price at which this was traded during the day and the closing price of the share at the end of the day are also given. Most publications give the previous close to enable the individual calculate and analyse the movements of the scrip. These figures are very useful for the technical analysts as well as the short term or day traders as they can use this to make their various decisions during the trading in the day.
There are two additional figures related to the volume generated on the stock during the day and the number of trades put through during the day. The volume generated is important as it gives an indication about the extent of the interest in a particular stock and the number of trades will show the kind of concentration of interest. There could be a case where there are a large number of trades but the volume does not go very high because these are retail trades. There can also be a situation where the number of trades is low but the value showing a large amount of big trades taking place.
Various value added figures are also given by the publications. These include the price-earnings ratio of a company. The price earnings ratio shows the valuation that is given by the market to a company. This is a tool that is used quite extensively to check for the position of the company in the market.
There is also the market capitalisation of a company, which shows the total value of the company. This is calculated by multiplying the number of shares outstanding in the company by the current market price. It shows the value of the entire company based on the current market price and hence has to be considered for various calculations. Another figure is the 52-week high /low, which shows the movement of the stock during the last one year.
Ratios of the company like return on net worth or return on capital or profit ratio or even balance sheet ratios can prove useful in analysis. There can also be figures like the beta, which measures the movement of the stock with respect to the overall market. If the beta of the stock is 1 then it is exactly in tune with the market movement. This means that if the market moves 10%, then the stock will also move by the same figure. On the other hand, where the beta of the stock is negative then this implies that the stock moves in an opposite direction to that of the overall market. If the market goes up then the stock would be down and vice versa. One has to be careful in interpreting this measure because the movement is not following the relation for a particular point of time but will be present over the average time period and hence one should not expect an exact relation every day.
There is the also the question of locating the stock that one wants to check out the price for. This is a very tricky issue as many times the stock gets shifted from one category to the other. In many cases, the A group stocks are given pride of place and are listed or information is shown about them at a particular place. The other stocks then follow after that and these are usually in alphabetical order. One has to be careful and look at the various heads under which this is classified so as to be able to have a better picture.
FACTORS AFFECTING THE STOCK PRICE OF A COMPANY
There are several factors that affect the stock price of a company, which is constantly witnessing some movements, as various investors are willing to pay different prices for it. The conditions that will impact the price are mentioned below but this is not a complete list as there can be other factors affecting it.
DEMAND AND SUPPLY
Many people will classify this under the head of technical factors. They are among the biggest determinants of the price of a stock. This is true especially in the short term, as the demand for the company’s stock will determine its price movement along with the supply available in the market. This is one of the reasons why the stock price of companies move up when there is demand from foreign institutional investors (FII) and there is not enough supply available in the market to meet the demand that is being generated from the big players.
Supply may be curtailed or increase suddenly due to various reasons. In a case where a large part of the equity is with the promoters any spike in demand for the company shares will straight lead to a price rise because there is no floating stock present in the market that will absorb this kind of demand. In other cases, where there are a lot of issue of shares then there is also chance of a fall in value because a large quantity of the stock is coming into the market impacting the price of the stocks.
INSTITUTIONAL INTEREST
A large part of the short-term movement in the price of a stock is also dependent upon the kind of investors that are looking at the stock or even buying the stock. In many cases, there are people or investors who closely follow what several major players are doing and then they base their investment strategy on these decisions. The sheer volume that is generated when the institutional players show interest in a stock and whether they want to buy the stock is a primary condition that can fuel further demand and interest in the stock. Again this is not a method of investing that any fundamental analyst will recommend and in many cases the impact of this is quite short term in nature. But there is also a feeling that institutional investors will not enter a stock till they have made the necessary study or due diligence and hence it is safe to invest in such companies. Mere FII interest is no guarantee for a rise in prices as many investors have discovered after a painful experience.
OVERALL CONDITIONS
The overall market conditions too have a role in determining the price movement of a stock. There are two major factors that impact the stock price movement and the first is the individual factors while the second is the overall market conditions. While the individual factor relating to a company is something that can be tackled by the route of diversification there is little that one can do when the overall market trend is negative.
It is often seen that in several cases the stock is falling even though there is no particular bad news related to it just because the overall market conditions are weak. Similarly, one can witness such a condition on the upside too and hence one would have to be careful in explaining the price change in such circumstances.
COMPANY SPECIFIC FACTORS
There are several company-specific factors that play an important role in the movement of the stock price. Most analysts look at the future performance and what is expected from the company while making an investment decision and valuing the company and hence this factor plays an important role in the overall scheme of things.
COMPANY PERFORMANCE
The manner in which the company is performing will impact the share price. This includes the financial performance as well as other parameters both financial as well as non-financial in nature. The financial performance will highlight the fact that it is in good shape and hence this will create an interest in the shares of the company from the viewpoint of returns generated.
There are several other parameters too in the form of the output sold, the realisation, the other income for the company, the operational parameters all of which will give an idea about the way in which the share price of the company will be traded. Changes in either of these will also impact the price movement of the company.
PROPOSED EXPANSION
Any proposed expansion plans of the company are watched very closely because they indicate the kind of future growth. The primary reason for investors to buy a particular share is that there will be some future growth in the company that will improve earnings or profitability. Proposed expansion plans wherein new capacity is added or they expand their activities will affect the earnings of the business. This will remain on the top of the attention charts for the investors and news of such events will have an immediate price impact as the proposed expansion is factored into the calculations by the investors.
ACQUISITIONS AND DEMERGERS
A lot of companies are now buying other companies and some are even going overseas to make acquisitions and these can prove to be an important factor impacting the performance of the company one way or the other.
In many cases the entire economies of scale are changed by such acquisitions. Demergers will change the financial working parameters. Margins and valuations will accordingly change in the market leading to share price movements.
STAGE OF GROWTH
A company cannot divorce itself from the industry in which it is working and hence the trends in the industry will have an impact on the performance and consequently the share price movement of the company. For example if the overall industry is going through a recession then even if the company is managing to hold its ground that is only a certain element that it can tackle. In such a situation the market will take note of the performance and then ensure that the price reflects the situation accordingly.
There are different stages of growth for the industry as a whole and the share price movements and the valuation will be determined by the stage of this also. A company falling into an industry which has a high growth rate plus a good potential in the coming years will have a different valuation as compared to a company that is in an industry which is slowing down. The impact of this will be clear and immediate in the stock price of the company.
REALISATIONS
There is also the way in which the realisations are working in the industry of the company. If the amount being billed is high that generates good margins and the amount is also being collected fully and without much of a problem there is little problem in terms of the cash flow that the investors will have and hence the price will be reflected accordingly.
On the other hand, where the realisation is not so easy then the business of the industry will be under pressure and due to this there will be an impact on the overall price of the company in the markets. The demand and supply situation in the sector will also impact the way in which the realisations work and hence a clear idea has to be acquired of the situation at this end.
COMPETITION
The competition that is being faced by the company both in terms of those from within the same industry as well as those who are outside the industry will be a determinant of the price movement of the shares in the company. The competition has to be analysed also from the angle of what are the new things that will impact the company and its performance going ahead. This can affect the entire planning of the company and consequently its share price. The details about the competition and its strength have to be studied to know what impact that this will have on the company as a whole.
GLOBAL FACTORS
Companies are increasingly becoming global in nature and global events can have a direct impact in the way in which they operate. This can happen suddenly and this can change the entire situation as far as the entity and the question of investing is concerned. If there is a company working in the commodity industry then the global prices of such commodities can be a very important factor as to how these companies will perform here in India. This means that any demand/supply change from any part of the world will have a domestic impact for the investor.
There are also various events that might be taking place across the globe but whose impact can be felt here. A surplus of denim in Europe can change the fortunes of local textile companies, similarly a very cold weather in some country leading to a crop failure can change the input cost equation for an entity. Such possibilities are endless ad hence the investors have to be careful about how such factors can change the situation on its head in a very short period of time.
LOCAL REGULATIONS
There are various regulations that companies have to meet in order to ensure that they are compliant with the requirements. Some regulations can wreck the future growth of a company; some may open a new opportunity. There is also the cost of complying with these that can prove to be a very detrimental for the entity altering the valuation.
For example, there was a premium for several companies like Infosys because of the fact that they were disclosing several conditions that was more than what the regulations permitted. Here, the regulations were used as a benchmark and then was used for changing the value of the shares in a company.
On the other hand, fulfilling some regulations like the Sarbanes Oxley Act in the US can consume lot of cost and time. These costs would be very difficult to recover. All these factors have an end financial impact and these must be considered by investors to value the company in an appropriate manner.
TAXATION MATTERS
Several benefits are available to specific sections of industry under the tax laws. Even locating in a particular part of the country can result in additional benefits. Similarly, the withdrawal of several benefits or a change in the rules and the law can hit some specific companies hard. All these have a direct impact on the way in which investors look at the share price of a company.
The taxation angle has to be seen carefully for several of the effects are long term. Whether such effects are tangible effect or the impact is just on the books where profits are transferred from one year to the other must be looked into.
FUNDAMENTAL ANALYSIS
Fundamental analysis involves looking at a whole host of factors including financial parameters and non-quantitative factors that are driving the performance of a company. This involves the study of these figures and putting it in context to various other developments that will affect the performance of the company. There is a very broad scope available for fundamental analysis. This can be extended by an individual depending upon their specific preferences and hence make the role of fundamental analysis customized to their needs. There are however some basics that are covered under fundamental analysis and one has to take a look at these items.
One aspect of fundamental analysis looks at the qualitative factors that affect a company. These could be quite varying in terms of scope and the perception of the analyst and their understanding of the position will impact their reaction to this.
The other side is the quantitative side, where the analyst considers various numbers related to the company. These are available from a large variety of sources. The figures can be obtained from a large number of financial statements available from various sources and when these numbers are used with the other information available about a company the overall result will be in form of the decision made on the investment.
Various quantitative measures used in the process of fundamental analysis are considered here. There are three main documents that are considered by the analysts when they look at fundamental analysis. These are the profit and loss account, the balance sheet and the cash flow statement. These statements tell you a lot and can be mined for a lot of information.
THE PROFIT AND LOSS ACCOUNT
The profit and loss account is the place where the current performance indicators of the company are available at a glance. This is where the income and the expenditure of the company are recorded and hence one will be able to know the profit generated by the company. The profit can be classified into various forms and hence one must be aware of the kind of profit that one is referring to as each term means a different thing.
There are two sides to a profit and loss account. This is the income side and the expense side. Both of these give certain information that can be useful for the purpose of fundamental analysis.
On the income side, the first and the biggest item that is witnessed is that of sales. Sales are the income of the company on account of the business done in various products or services. A rise in this figure is a good sign as it shows an increasing level of business. This is a direct indication of the state of the business being conducted by a company.
Then there are other items that contribute to the income of the company. This could be something like sale of scrap for a manufacturing company. For other companies there would be income from the investments that it has made of the surplus funds lying with it. This would be dividend income from shares as well as mutual funds and interest from debt investments made and this would add the total income of the company. In many cases, there might be sale of some assets like land or building that would result in a profit and this would be shown on the income side of the profit and loss account.
Similarly, there might be some assets of the company in the form of investments that might be sold at a profit and this profit will be counted as part of the total income. It has to be noted that all these other items that contribute to the income are known as non-core items and would go under the broad head of other income.
There will be a slight change as far as the figures of a financial entity like a bank is concerned. Here, the income side will have income but interest income for these entities will be core income because they are in the business of lending and borrowing funds. For these entities the interest income is closely watched as it is the core income and if income from lending activities rise, then it is a very good sign. There might be other interest income like interest on investment and that on balances kept with the Reserve Bank of India.
For financial entities, the term other income would include profit on sale of securities which is present for other entities too. The other income figure would have additional heads like commission on foreign exchange and other charges that it earns on services.
On the other side of the profit and loss account are the expenses. For a manufacturing company, there would be purchases and other manufacturing expenses while for service firms there would be different kind of working expenses. This is the core expense and the profit after this would be gross profit for the company. When other administrative, selling and distribution expenses are removed from the list then the expense list would be complete and this would include all the operating expenses of the company.
There will be interest expenses that have to be considered and these will be a very important component as this figure is watched quite closely for the kind of borrowing of the company and the impact that it has on the profit figure. This should not be too high in such a situation that the company is not able to pay off the interest cost.
Another important item that is considered by analysts is that of depreciation. This is the figure reduced from the profits for the wear and tear of the assets of the company. It is watched very closely for it has an impact on the financials. In many cases, where there is a large investment there is a huge depreciation figure and even though this is a non-cash expense, which means that there is no cash outgo for this expense, the impact on the profit would be witnessed in the financial statements.
There is also the provision for tax, which is a closely watched for it gives an indication of the overall performance of the company in terms of the final earnings. Now, there is a provision for tax as well as a provision for deferred tax that has to be made because the accounting impact due to the accounting standards has to be shown in the financial statements. This can sometimes affect the final profit figure of the company. The figure is called profit before tax and the one after the impact is given is called the profit after tax or the net profit figure.
BALANCE SHEET
The balance sheet is a document that outlines the position of the business as on a particular date of the year. This means that a person will be able to get the exact position of an entity on that particular day by looking at the various items in the balance sheet. One has to look at each of these items carefully as this will give a true picture of the situation and one must also realise that the position will change after that day as other financial activity is given impact to.
There are two sides of a balance sheet and this has to tally at a particular time when the balance sheet is prepared. The liabilities side of the balance sheet has items where the company owed things to outsiders while the asset side cossets of the various fixed assets, investments and other current assets, which consist of the assets of the company or the amount that is owed to it by other parties.
The liabilities side consists of several items. The first is the share capital. This is the capital that has been subscribed and paid up by the investors. This shows the number of shares that are outstanding and hence this will be used to calculate a number of ratios and figures.
Then there are reserves and surplus. These consist of various reserves, which is the amount of profit that is transferred to the reserves after various other items are taken care of. The reserves will be classified under various heads depending upon the purpose for which the reserve has been created.
There are borrowings, which is a very important component of the balance sheet. This consists of two items, which are secured loans and unsecured loans. Secured loans are a borrowing of the company that is backed by security of various assets of the company. This is made by borrowings from banks and other financial institutions. In addition, there are various other borrowings to which are not so secured. These come under the head of unsecured borrowings and are often for the short to medium term.
Then there are current liabilities, which are amounts that have to be paid by the company. This includes sundry creditors where the amount has to be paid to entities from whom purchases have been made plus other outstanding payments that have to be made in a short period of time.
The other side of the balance sheet is the assets side. That also has a lot of figures that are to be considered for the purpose of various analyses. The first item on the assets side is fixed assets. This includes items like land and building, plant and machinery, furniture and fixtures that are owned by the company. These represent assets that are present in the books and the benefit of which will be witnessed over a long period of time. It is not necessary that all the assets have to be physical assets. Some of them can also be intangible assets that do not represent anything that is physical but still gives benefit to the company over a period of time.
Investments come next. These are the various amounts that have been invested in other instruments that will give them ownership of these investments. Some of the investments are in companies that are subsidiaries of the main company or they belong to the same group. These are equity investments and in many cases the company will hold a large part of its capital in such entities.
The other part of the investment section is where the investment is made in equities of other companies ether as a strategic investment or even as a pure investment where the company gets the benefit of dividend and capital gains. Another trend that has been witnessed in recent times is that there is a lot of cash floating around with companies. This is either due to a high cash flow or it could be because of the fact that the company has raised a large amount of money that has not yet been invested.
This money now typically goes towards mutual funds and that too short term debt mutual funds like liquid funds or short term plans where there is very low risk and the investor can earn some returns. Thus, these short term schemes as well as liquid schemes of mutual funds that are held by the companies gives them dividend or capital gains when they are sold. An interesting thing to note here is that there are several investments, which will not show on the balance sheet because they are bought and sold during the year and hence there is no outstanding at the end of the year to be visible on the balance sheet.
Current assets will include items like stock, cash on hand and sundry debtors plus other current assets. Stock refers to the closing stock of various items that is present with the company at the end of a particular period. A very large amount held in stock that is increasing over a period of time is also not a very good sign as it shows a larger amount being stuck in the stock that is slow moving.
Then there is the cash and bank balance. This includes the actual amount of cash plus the various balances lying in the bank account while the sundry debtors are the sums that are remaining to be recovered from customers, who have bought goods but not yet paid their respective amounts to the company. Other current assets are several other sums that do not fall into these categories but are still remaining to be recovered from various parties.
Finally, there is the figure of miscellaneous assets, which consists of various items that are being written off over a period of time and are not yet fully written off yet. These will keep reducing with each passing year as a larger part of this is written off to the profit and loss account. Another item that has made its appearance in recent times has been deferred assets or deferred liabilities.
Thus the balance sheet gives an individual a complete picture of the financial position of the company. In case of different types of companies there can be several items that will differ a bit and hence will have to be taken into consideration.
CASH FLOW STATEMENT
A cash flow statement states the cash inflows and outflows of a company. It makes the user clear as to where funds are going and where they are coming from. There are several components of a cash flow statement and these have to be understood carefully for the indications that they give on the financial position of a company.
The first part of the cash flow statement is the cash from operating activities. This is the figure that will reflect the cash that is either generated or being spent on activities that are central to the overall performance of the company. This figure is calculated adjusting all the non-cash items with the net profit and to get the cash profit. Further, the changes in the current assets and liabilities are also taken in to consideration to arrive at the cash inflow or outflow. This will be the cash flow from operations.
The simple interpretation of the cash flow from operations is that it is generated from the operating activities of the company. Core performance results in this cash flow, which is then adjusted in other areas as per the need of the company. A positive cash flow from operations is a good sign and investors have to consider this factor while evaluating the company.
The next part of the cash flow statement is the cash flow from investing. This part consists of the various investments made by the company into assets like fixed assets or even into various other investment avenues. There will also be an amount that is an inflow from the various investment avenues in terms of dividends from subsidiaries and even some money coming back for the company. These will give investors an idea about how the funds are being used for investment purposes.
There is also the part of financing for the company where the amount raised by the company from sources like a new issue of shares or issue of debentures are shown on the receipt side while the repayment of debt and other forms of borrowing will go to the outflow of the finance side. This will show the amount that is either contributed or given to the financing side during the year.
In many cases, it will be witnessed that there is an outflow on the investing side. This means that the company is putting money into more assets and other forms of investment. There can also be a case where there is an outflow on the financing side, which shows that it is paying out more money in redeeming bonds and other debt from the funds available from other sources.
If there is some anomaly in figures for a particular period of time, it is not a big cause for concern because depending upon the characteristics of the company or the position that it finds itself in there would be a certain way of activities that would be visible through the cash flow statement. However, if such anomaly continues for a long period of time or this looks as if it is not sustainable then there one would have to look at the entire situation very closely to monitor the kind of changes that are happening.
COMPARATIVE STATEMENTS
There is a technique of analysis that is implemented by analysts because this determines the comparison in the various parameters of a particular company. This way of comparing performance is known as comparative statement. All the financial statements for several time periods are kept side by side and then the percentage change for each year is calculated to arrive at the way in which the things have moved.
This kind of comparison will give the investor an idea about the company’s performance over a period of time. For example, the change in the sales and the operating expenses figure over the years will give an indication of the way in which these figures have been developing for the company.
A proper analysis of the various comparative figures of a company will give an indication of its strong areas and the steps needed to ensure that the performance moves in the right direction. There is a limited amount of information that the comparison can give you especially in a situation where there is major action of a merger or a demerger on account of which the past figures are not comparable.
Changes in terms of accounting processes or some other procedural reasons can sometimes skew the inferences from comparative statements. This does not mean that the comparative analysis is useless but that this should not be the only point used in the analysis. It can be used with several other measures that will give a complete picture.
COMMON SIZE STATEMENTS
Under the common size statements all the figures in the financial statements are converted to a single base and this will ensure that one can get a proper view for various companies. The absolute figures can be very misleading in many cases and to make them comparable, they have to be converted to common size statements.
Converting every figure to a percentage of a common base for that particular year can do this. For example, the items in a profit and loss statement can be converted as a factor of net sales, which is fixed as 100.
Similarly in case of the balance sheet the figures can be converted on the common base of the total assets figure. Since in a balance sheet the total of the assets side and the total of the liabilities side will match either of the figures will be acceptable as they will be the same. However, if there is a change in the format of the balance sheet for a particular company, then this has to be highlighted to avoid making it a comparison of apples and oranges.
RATIO ANALYSIS
Ratio analysis is one of the basic tools in fundamental analysis. This will help an investor to understand the position of a company in a better manner and help them in making their investment decisions.
Ratio analysis is not just about taking numbers and putting them against one another to arrive at some additional figures. This is also about looking at previous years figures comparing the numbers with those figures or looking at the figures for the industry, the competition and then relating all this to how a company has performed in the past and how they will perform in the future. The method for calculating ratios given illustrated here are commonly used. However, some analysts may adopt a slight variation of these methods to suit their specific needs.
THE LIQUIDITY RATIOS
CURRENT RATIO
This ratio is calculated to ensure that the company is liquid in its operations and that it will not face any problem in maintaining its short-term operations. This ratio is known as the current ratio and is calculated by dividing current assets by current liabilities. The ratio will give an idea about the position of the company in the short term. It will highlight the liquidity present in the system in terms of the immediate receipts and payments that will have to be made. A ratio above 2 is considered safe though this figure would vary depending upon the industry that one is in.
Formula:
Current ratio = Current assets /Current liabilities
QUICK RATIO
Quick ratio is a variant of the current ratio and it excludes those items that might take some time to be converted into cash. This means that the items of stock is removed from the current asset side because this cannot be converted into cash overnight and hence the ratio will consist of current assets less the stock figure divided by the current liabilities. This is an even intricate measure of the financial position of the company, as it will give a better picture of what will happen if the entire thing has to be liquidated at once. This is also known as the acid test ratio and a figure below 1 is usually not desirable though a very high figure will also signify improper use of the capital.
Quick ratio = Cash + Debtors + Short Term Investment/Current Liabilities
DEBT RATIOS
DEBT EQUITY RATIO
This ratio will help one to know the extent of debt and equity present in the balance sheet and whether the company has the capacity to raise additional debt. Financial institutions and other lenders will not lend to a company above a certain limit and the debt-equity ratio is an important indicator of this. This is calculated by dividing debt by equity. For this purpose the equity figure will be put against the long-term borrowings of the company. The standard figure of the debt-equity ratio will differ from industry to industry and hence one will have to be careful in interpreting these figures.
Debt equity ratio = Debt/Equity
A very high debt figure is not a good sign as it could show that it could be difficult to service the debt in the coming days. However, there are different figures for specific industries where the figure might just jump very high due to the capital-intensive nature of the industry and this factor has to be taken into consideration.
DEBT SERVICE RATIO
This ratio will show whether there are funds available with the company in order to service the existing debt. This figure is calculated as the earnings before interest and taxes divided by the interest payment and debt repayment on the loan during the year.
This figure gives an indication about the amount of funds that the company is generating to meet the debt obligations during the current year. A figure less than one is a cause for concern as this shows that the earnings of the company are not sufficient to service its outstanding debt.
INTEREST COVERAGE RATIO
This is a variant of the debt service ratio but the aim is to find out the ability of the company to service the interest payments. This is calculated as the earnings before interest and tax divided by the interest expenses during the year.
The ratio indicates the proportion of earnings available to meet the interest expenses. This will also give an indication of the borrowing of the company and whether this is sustainable. The figure should not fall below one though a little bit of margin is also desirable for safety purposes.
INVENTORY TURNOVER RATIO
The inventory turnover ratio shows how quickly the inventory of the company is moving and is completing its cycle. This inventory figure of the company is that part of goods that is not sold. Hence, it has to be measured against the cost of good sold of the company. Further to get a better picture of the inventory figure, the average inventory is considered. The average inventory is the opening inventory plus closing inventory divided by 2.
Inventory Turnover = Cost of goods sold/Average Inventory
If the inventory figure is not turning over very quickly then it shows that there are slow moving items that are restricting the sales and the operations of the company.
NUMBER OF DAYS RECEIVABLE
Debtors are the customers and other entities who owe money to the company. It is necessary that there is a quick settlement of the dues that have to be received so that money is not stuck for a very long time. This will give the average number of days that it takes for the money to be collected from the debtors
Number of days receivable = Sundry debtors/(Sales/365)
A larger number of days for collection mean that the money is stuck in the process for a long time and is not witnessing a quick turnaround. Credit facility to the customers is tolerable up to a certain level as it is necessary in the business. But if the period is unreasonably long, it could become a drag on the performance.
ASSET TURNOVER
This ratio gives the proportion of total assets employed in relation to the sales of the company. It shows how the assets of a company are being used to generate sales. Usually the higher the figure in this ratio, the better it is.
Asset Turnover = Net sales /Total assets
RETURN ON EQUITY
This is one of the favourite ratios of investors as they check for the return that is being generated on equity. It shows the return earned by equity shareholders of the company on the money invested in the company. This is the earnings of the owners of the company
Return on equity = Profit after tax/Shareholders’ equity
A higher return of equity is good for equity shareholders and shows that the company is giving them good returns. The ratio is also known return on net worth.
RETURN ON CAPITAL EMPLOYED
This figure gives an indication of the returns earned on the asset base of the company both equity as well as debt. This is a broader term and will give an indication of how the total assets of the company are earning.
Return on capital employed = Earnings before Interest and tax / Capital employed
In the calculation, the interest payment is added to profit after tax since returns earned by debt holders must also be included. A company has to ensure that the return on capital employed is higher than the cost of borrowing.
BOOK VALUE PER SHARE
This gives an idea of the balance sheet strength of the company. It shows how much each share of the company is worth according to the value on the books of the company. There are two ways deriving this figure. One is to take it directly take it from the liabilities side where the figure of shareholders equity is available. The other is to take the asset side total and remove all the other outsiders’ contribution from it.
Book value per share = Shareholders equity/ Number of shares outstanding
NET PROFIT RATIO
This ratio shows the percentage profit that the company earns on sales. The higher the ratio the better it is and it is calculated by dividing net profit of the company by the net sales and multiplying it by 100.
Net profit ratio = Net profit/Net sale * 100
EARNINGS PER SHARE
This figure shows the actual earning by the company for each share that it has issued. Shareholders get an idea of the net profit available for each of them.
EPS = Net profit/ Number of shares outstanding
PRICE EARNINGS RATIO
The price-earnings ratio gives an indication of how a particular company is valued in the market. It shows the price that the market is willing to pay for the earnings recorded by a company. A high P/E ratio means that the market is expecting a higher return from the company or it has several features that will enable it to earn a higher amount than several of its peers in the industry. Growth stocks usually receive a higher P/E.
P/E ratio = Market price per share/ EPS
TECHNICAL ANALYSIS
Market players use technical analysis to predict various price movements. There is a clear demarcation between technical analysis and fundamental analysis. The latter looks at the performance and other factors of the company while technical analysis looks at completely different factors related to past market data.
The objective of technical analysis is to predict or forecast the short, intermediate and even the long-term price movements. In order to achieve this, a heap of data is used. This is market data generated during trading. Analysts use graphs and indicators to make sense out of the data.
There are several assumptions that go into the process. The first one is that the market value is determined solely by the interaction of demand and supply. The normal movement in either of these factors will impact the market value of a company.
The supply and demand is also governed by a large number of factors, both rational and irrational. There is no need that the factors impacting the supply or demand be rational in nature. They impact supply or demand of different stocks in different ways.
Stock prices move in trends and one has to identify these trends to invest shrewdly. The trends persist for an appreciable length of time. This shows that there are also long-term trends and these can prove to be beneficial for the investors. For a trend to change, there has to be some underlying factors that will impact the movement.
The key is to identify the shift and how this occurs. Technical analysts believe that the shift in demand and supply can be detected by analysis of the various charts available and there are chart patterns that keep repeating. There are conditions when technical analysis will fail to work. One has to understand this because there is no way that the technical analysis will work under all circumstances. Therefore, there has to be a reality check on what will happen after making an inference from technical analysis. This works better in a market environment where price reflects information but there is a time lag between the arrival of the information and the impact witnessed on the price of a company.
This entire process of information being reflected in the share prices is a bit slow and this gives technical analysis an opportunity of being useful.
FOCUS
The focus of technical analysis is to the timing of various investments and the likely price changes that will occur. Many investors would have heard that they should not time the market but should invest consistently over a period of time. If one has to use technical analysis then the idea is to focus on the timing and the kind of price changes that will occur on account of the changes.
The entire focus of the analysis is on these factors that are available in the market. The data for this is being generated in the market and this is available to the investor. This includes items that one sees quite commonly all over in the form of price, volume etc.
Another thing that most investors will also notice is that the focus is on short-term changes in the price even though the technical analyst also does intermediate and long-term forecasts.
The focus is more on the direction of the movement of the price and not so much on the exact price. The directional movement will result in a lot of gains coming in for the investor. In addition, the process is easy and fast to adopt and it can be applied to a lot of stocks at the same time. There are several components of technical analysis. Let us see some of them to have an idea about the way things operate.
DOW THEORY
The most famous theory is the Dow theory that was put forward by Charles Dow. The theory seeks to determine the changes in the primary or major movements in the market. It believes that there are three movements in the market. The first is the primary or long- term movement, which lasts from several months to years. The next is the secondary or intermediate movement that can range from weeks to months and the final is the daily fluctuation or the short-term movement that can range from days to weeks.
Here the price-volume relationship is important and price changes have to be supported by the necessary volume. A fall in volume in a trend signals a change in the trend. There are two phases in the movement. In a bullish phase, the price hits a new peak every time and when it fails to touch a new peak it is considered the end of bullish phase. On the other hand, when the price is hitting new lows then it is a bearish phase and when the price fails to create a new low then it is the end of the bearish phase.
CHART ANALYSIS
It is the process of looking at price and volume charts to get various data. The idea is to look for a pattern within the charts and also look out for the reversal and break outs that can change the situation. Here, the prices are converted into various indicators that can then be used for the purpose of making decisions.
One of the common ways to do this is by using price trends that can be upwards, downwards or even sideways. Then there are trend lines drawn where the lines show a certain pattern or movement of the prices.
MOVING AVERAGES
This method is used quite extensively in technical analysis. In the process of moving averages the first thing that one has to do is to select a period. There are several figures that can be used to calculate the necessary moving average. The selection is more important than the figures themselves, as this will enable proper interpretation. The price then has to be put in conjunction with the moving average. The behaviour of these two have to be considered. When the price penetrates the moving average from the bottom this gives a buy signal and when it penetrates from the top this gives a sell signal.
The moving averages are used as support or resistance levels for a trend that is prevalent in the stock.
OSCILLATORS
This brings us to another concept called oscillators that are used in the process of technical analysis. In the case of oscillators, there are no patterns as seen in the price charts. Rather, the situation is classified as being either overbought or oversold. The oscillators normally move within a range and there is no visible bull or bear phase from these oscillators. The good thing about them is that they can be institutionalised and trading rules can be generated from the oscillators.
There is another great advantage of using this route. There is a clear interpretation for various oscillators and hence there is no question of trying to look for patterns to make decisions. It makes decision-making a simpler process.
They are generally used for the short term as they give decisions about the action to be taken instantly. But since they often fail, careful interpretation is advised. Given below are a few oscillators and what they actually mean.
MOVING AVERAGE CONVERGENCE DIVERGENCE
One must keep in mind a lot of technical issues while calculating these indicators. It is defined as the difference between the 12 and the 26 days exponential moving average. The figure above zero indicates an overbought situation and hence calls for a sell. A figure below zero indicates an oversold situation and hence a buy.
PRICE RATE OF CHANGE OR MOMENTUM
This figure compares the current price with the previous x day’s price and then calculates the rate of appreciation or depreciation. A figure less than zero indicate an oversold position while a figure above zero indicates an overbought position. This requires careful interpretation and is used mainly for the purpose of price estimation.
RELATIVE STRENGTH INDEX
This oscillator compares the number of up ticks and the number of down ticks. It believes that reaction takes place periodically in the market. This figure moves between 0 and 100. Above 70 it indicates an overbought position and hence the trend is bearish while a figure below 30 indicates an oversold situation and the trend is bullish.
STOCHASTIC OSCILLATORS
In this method a particular period is taken into account. The difference between the high and the low is calculated for this period. Then the difference between the close for the day and the lowest low in the period is considered. The ratio of the above two figures will give the indicator. This moves between 0 and 100. The general rule is to sell above 80 and buy below 20.
VOLUME OSCILLATORS
The moving average for volumes for a short period and along period is looked at under this method. The difference between the two moving averages is calculated. The trend is considered to be weak if the difference increases with a fall in price or the difference declines with a rise in price. The situation is bullish when the opposite happens.
DIFFERENT STYLES OF INVESTING
Investing in the stock market calls for use of specific ways of selecting stocks for investing. Most fund manages follow a particular style. The legends of the market establish a place for themselves based on the way in which they make their investment decisions and the success that this has generated.
These styles are characterised by the way various stocks are selected and the process that goes behind the stock selection. Here are some styles.
GROWTH INVESTING
Growth investing looks at selection of stocks that have a high growth potential and are hence expected to grow faster than the other players or the industry. The other way of looking at growth stocks is seeing if they belong to an emerging area, which is expected to show great growth. Such companies are first identified through a long process and there are different approaches adopted by investors. Some directly identify companies with a potential for growth while other select growth areas and then particular stocks from these areas are selected for investment. It is expected that profit and share prices would beat the market over a long period of time in such companies.
The growth scrips are studied for the reason as to whether they will deliver higher earnings growth that the corresponding companies around for the purpose of selection. The growth companies are supposed to be on the higher side of the earnings curve and they are in the growth phase of their life cycle, which means that they will be witnessing rapid rise in the sales and profit figures.
Investing in these companies gives investors the benefit of gaining more than the market from the fast rise in the companies. One of the basic conditions in this kind of investing is the way in which the markets will perceive this stock. There is a belief that the market will value the growth stocks in a different manner and hence contribute to the valuations.
Growth companies are in that position because either they have a new technology or they dominate a certain niche in the market. The belief is that the investors would be willing to pay a high multiple for the growth-oriented shares.
This style of investing is quite popular, as a lot of investors would like to ensure that they have the right kind of stocks in their portfolio that are showing an element of growth. This is one of the basic styles of investing developed over generations in the market.
VALUE INVESTING
This is another investment style that is also quite widely used by a range of fund managers. There is a vast difference between the growth and the value style of investing and hence an entirely different way of thinking is required to tackle it.
Value investing involves identifying shares that are undervalued at a certain point of time and then investing in these companies to gain from a situation where their values will reflect their intrinsic worth. There are several ways to find this from various indicators that are seen while making the decision. One is that of a low price earnings ratio plus there is a quantitative criterion that looks at various asset values. The focus is also on cash flows and on discounted future earnings. Other factors that are often considered include lower than average price to book ratio or even high dividend yield. There is also a qualitative issue involved and here the investor will have to make a judgment about the business, the markets that it operates in, the management and its ability to ensure future growth from its industry.
Value investing can take quite a lot of time to show results and in many cases this might not even happen. There is no certainty as to whether and when the particular share will come back to the level of its actual worth. Often this can take years and hence it is quite popular method to be used by people who are able to hold on to their investments for a long period of time.
There are several other styles of investing. One has to distinguish them from the top two styles of investment namely growth and value investing. These other investment styles are methods used by fund managers and investors while picking stocks.
MOMENTUM INVESTING
Momentum investing is a style used by investors looking for quick growth for their investments. Many people think that this can also be linked to growth investing except for one small detail. Under the growth style of investing, the investor picks up stocks that are on the growth path and these are showing several fundamental factors that show that it is in a phase that is witnessing better prospects that will provide support to the valuations. Under momentum investing, the price of a share is moving in a particular direction either upwards or downwards. Based on this, the time for which this movement is expected to continue, the decision is made.
The companies selected under this method are the fastest growing companies and their stock is also moving rapidly in the market. The company also often shows dramatic growth in earnings, has a high price-earnings ratio, it is outperforming a large part of the market, there is a high volume in its stock.
There are a lot of occasions when the company is witnessing a rise in prices because of some conditions but the rise becomes far more than what would have been expected. This is on account of the large amount of interest in the stock that is pushing the momentum upwards. In such cases, there is a style of investing wherein the stocks that are showing this kind of movement are selected and then raised for an investment.
There often might not be any fundamental reason that would back up such a momentum style of investing but that is not important. The rise in the value and the direction of the investment is the key factor that is driving the investment. This investment style would also require the ability of a quick exit because one might have to get out of a stock before there is a turnaround and a fall in the value
DIVIDEND YIELD INVESTING
This style of investing is also quite popular and there are a lot of dividend yield funds that are present in the market. The emphasis of this method of investing is on the ability of companies to generate dividend.
Dividend yield investing will focus on those companies that have a high dividend yield figure. Dividend yield is calculated as the dividend per share divided by the market price of the share and the higher the figure the better it is for the investor. This figure shows the kind of money that is being generated by the investment from dividends as percentage figure of the total cost of the investment.
There is also the assumption that such high dividend yield stocks will do better than the rest of the market during certain time periods. Various studies to this effect have been done and they paint different pictures about the performance one can expect during different time periods. There is no certainty about this kind of performance and hence there is no surety of the investment principle actually working out the way it should be doing.
There is also another danger in this route of investing. Since there is a lot of focus on the dividend side of the transaction, often requisite attention is not given to the capital gains side of the deal. In this situation, it is very much possible that the dividend yield that has been generated on the scheme could get wiped out in one blow from the capital loss that the scheme suffers on account of the fall in values in the market.
GREAT STOCK MARKET INVESTORS
There have been several great investors in the last century. A few of them will be remembered in history for the role that they played in the equity markets. Here is some interesting information about those greats collected from various sources including the internet.
WARREN BUFFET
Warren Buffet is known as the sage of Omaha and has become one of the most famous investors across the world. He is also one of the richest men in the world today. All this is all due to the returns earned by his investments. He started out as a disciple of Benjamin Graham and his style of value investing. But over the years, he developed his own unique style to become a legend himself.
He looks for opportunities as they arise and then makes full use of them. One thing that will strike a person is that he does not do anything flamboyant or flashy that will attract attention. Recently, he gave away a large part of his entire wealth to the Gates Foundation for charitable purposes. His belief is that the business world consists of two types of business – one that is worth investing in and the others that are not and he seeks opportunities to buy the good ones.
Buffett actually started out doing business when he was just 15 at Woodrow Wilson High School in Washington. He and another kid put up reconditioned pinball machines in barbershops. They made quite a bit of money in this venture though on a small scale. This enabled him to buy a farm for $1,200. He was also retrieving and reselling golf balls and running paper routes.
Buffett went to the University of Nebraska and was fascinated by stock technical analysis but he soon gave that up. Later, he went to Columbia University because Benjamin Graham was teaching there. He worked for a couple of years with Graham and then returned to Omaha.
He started from scratch and his earnings came from picking stocks and companies for investment. His greatest achievement is that over a period of decades, he outperformed the market without taking any unnecessary risk to achieve the target. He used the power of compounding to the best effect. For anyone who wants to know whether the theory works in real life here is a live example to answer the question.
The remarkable achievement of Buffet comes through times both good and bad as the world went through several tough phases. His approach was long term investing, which was clearly different from the other approach of coming in and taking a stake and then selling out to the other investors at the right time. Another significant thing was that public shareholders also gained significantly from their investments with Buffet and this showed that all his gains were not for himself only.
He made the process of investing look simple and easy to understand. The features of discipline, patience and rationality characterised his life. He is famous for two things one for not investing in a company or a sector that he does not understand. This was witnessed during the internet boom when the world went running after these stocks but Buffet chose his own path. Second is the interest that is generated when he makes his annual address each year and the number of people who listen to it.
There is a tremendous focus on the work that goes behind the investment decisions. He is a very private person in spite of the large amount of media glare that he receives.
PETER LYNCH
Peter Lynch is regarded as one of the masters of Wall Street and he built up this reputation while managing the Fidelity Magellan Fund. Such was his aura that he is regarded as the father of the Magellan Fund. After he took charge of the fund, it became the largest mutual fund in history. Further, his reputation grew as he turned out performance year after year that beat the market.
Peter Lynch had a tough childhood as his father died when he was ten and his mother went to work for a manufacturing company. Peter moved from a private school to a local public school. He attended high school in Newton, Massachusetts. Interestingly, he came into touch with the stock market when he worked as a caddy. He overheard businessmen discussing the stock market, while playing golf.
Peter Lynch then made his first investment in a stock and this went on an upward spiral getting him amazing returns. He slowly kept selling a part of his stock as the rise continued. In the meantime, he had finished college at Boston College and had a summer job at Fidelity. He got enough money on the stock to enable him to pay for his graduate study at the Wharton School of Finance.
Later, he moved full time to Fidelity and after some time after doing work in the analytics section became director of research and later went on to manage Fidelity Magellan Fund. There are quite a few principles that Peter Lynch follows and these are interesting to note. Among his style of management was that he would encourage people not to tear down each other’s ideas because he felt that there was something that one could learn from each of these ideas and several of them could be very valuable too.
The way to make money for him was quite clear as he clearly believed that to make money you must find something that nobody else knows or do something that others wont do because they have rigid mind sets. Thus, you had to be ahead of the market and this meant getting several insights that is difficult for others to get. This often meant that ideas have to be conveyed quickly and therefore he also felt that there is no relationship between the length of a recommendation and its value. Short and sweet was his mantra as long as the basic idea was conveyed and there was value in the idea.
One of the basic investment principles that Lynch emphasised on was to catch the turn in the company. This is nothing but the time period when a company not doing too well is trying to turn around but the same has not been reflected in the price as yet. This once again goes back to his principle of being ahead of the market. If one is able to invest in the company before this happens then there is a lot of gain to be made. He believed that experience of being in the market and working there should give one the ability to undertake this kind of analysis. Another of his principles is about company visits and he visited a lot of companies to get a better feel of what is happening. This gave him first hand experiences and additional insights that would not have been possible otherwise.
BENJAMIN GRAHAM
Benjamin Graham is probably one of the greatest investment gurus of Wall Street. He is well known for his quantitative approach to investing. Two of his works, Security Analysis and The Intelligent Investor, are considered masterpieces on investment, which every investor must read.
He came to New York when he was a little child with his parents. His father died when he was young causing some financial problems for the family. This instilled in the mind of Benjamin Graham the need for financial security during his lifetime. He graduated from Columbia University and after that he went to work in Wall Street as a messenger. Soon, he progressed to doing write-ups and analysis and started publishing them in financial magazines.
He had a wide variety of interests. This ranged from the Greek and Latin classics to philosophy and the languages. He translated a book and even wrote several of them himself. In 1926, he formed a pool, the Benjamin Graham Joint Account, which he managed for a share in the profits. However, the market collapse in 1929 and 1930 hit the account hard but it still managed to survive in the market.
He then taught an evening course at the Columbia Business School. He published several books. Graham believed that one of the important factors in the moneymaking business was to distinguish between investments and speculations. There is a certain process that has to be followed in the investment process. There has to be adequate analysis, an element of safety in the capital and there should also be an adequate rate of return for the investor. When these factors are lacking, the investment becomes a speculation.
He believed that the earnings of a company consist of dividends plus the increase in the net assets per share, which is evident in the figure of the surplus in the company. Some of the factors that he looked at in stocks to determine their earning capacity were the debt equity ratio, earning stability of the company the dividend record and price in relation to the tangible assets of the company. He also believed that there was value left in companies that were available on the exchange for a value that was less than their net asset values. This calculation was also used to find out the overall situation of the market as a large number of companies were quoting below their net asset values showed that the market was depressed. His principles are followed to this day and his books still remain bestsellers and a must read for every investor.
JOHN TEMPLETON
John Templeton follows the deep value contrarian style of investment. He was born into a poor family and his tryst with the markets began before the Second World War, when he joined a brokerage firm in New York.
At the outbreak of the war, he framed a strategy to gain from the situation by buying all the shares that were quoting below $1. He was extremely successful in this as he managed to turn $10,000 into $40,000 over the next four years. This was his first brush with stocks and after that there was no looking back.
He launched his own investment advisory firm and his strategy was to buy stocks that provided value. This meant that he purchased a large number of shares and hence a good performance by a large number of them made returns for him. He followed some guidelines, which have become well known the world over. This included earning real returns after paying taxes, stay with an open mind and develop flexibility in the investment process and not to follow the crowd when they are going in a certain direction.
Among his beliefs in the way markets work was that there is nothing permanent and bear markets as well as bull markets will change. In addition, one should learn from their mistakes and buy shares during times of market pessimism when people are not ready to buy. This requires following a process of hunting for bargains and getting a good price.
John believed that one should look across the world for the best bargains. In that sense, his decision to invest in Japan in the sixties was a notable decision that proved to be a money-spinner as the country developed into a major economic force in the next two decades. He also believed that nobody knows everything and one should always be prepared to accept this point and learn from the experience.
In terms of the financial factors that he considered while making an investment selection were the price-earnings ratio, the average growth of earnings, the operating profit margins and the liquidating value of a company.
He followed several of his beliefs very carefully. One was to buy only those things that were being thrown away by other investors and they were not ready to even look at it. His plan was to buy such stocks and hold it for more than 3-4 years, which gave it the required time to realise some of the potential that was present.
After selling off his initial business Templeton started off once again at a time when most other people would be considering retirement. He moved to Nassau, where he built a house. From here, he managed one fund where he and his clients had most of the shares.
One of the key factors visible in his investment style is that he looks at many markets. At the same time, he was prepared to invest in companies that very few people had heard of. These two principles form the basis of his overall philosophy. There too one has to look out for companies that are being valued at a very low percentage of their true worth. While there are mistakes in the process the best bets turn out to be those companies that investors do not even consider worth looking at.
Two other factors that he considers while making a choice are the government control and the risk of inflation. There is also a standard list of questions that he asks management, which includes talking about the competitors and which of them is the most serious threat to the company. Among ratios and financial figures, he feels that there are four factors that are important and need to be considered. These are the price earnings ratio, operating profit margin ratio, liquidating values and the consistency of the growth rate of the company.
T ROWE PRICE
A long bull market is a nice time to make money and this is especially true for all growth investors who have done their homework well. T Rowe Price was one of the foremost believers in the growth investing philosophy and this paid him rich dividends through his investing career. His name is associated with an entire style of investing. It was a very popular approach of looking at stock on Wall Street and there exists a whole list of die-hard investors who follow his route in their investment process. He founded an investment management firm named the T Rowe Price. One of his basic beliefs was that what is good for the client is also good for the firm. Initially, he did not charge a commission but a fee on the assets under management, this meant that both the parties benefited in the process.
He was trained a chemist but had a great passion for investing. His name is linked to the growth style of investing. He was the head of this firm till his retirement. He was a strong willed person who followed a strict agenda that he set for himself. He was a very organised and disciplined man and the habits of his life was witnessed in his investment too as he would sell a stock at the exact level that had been set for it.
His habit was to start a fund and then move on to some other fund. He sold off his firm to his associates when he believed that the prices had reached very high. After this, he moved to a cautious and diversified approach that paid him rich dividends in the following years. The growth approach that was advocated by Price was always in competition with several other approaches that have dotted the investment landscape. His philosophy was that the best way in which an investor can make money is to look out for areas of growth and then hold stocks in this area for a long period of time. The key here was the definition of a growth company. This was a company that shows long-term growth of earnings, which reaches a new high at the peak of each succeeding business cycle.
Price believed that the best time to own a stock was when the company was in the early stages of growth. The continuation on the growth path will provide the earning opportunity. After maturity is reached, there will be a higher risk element in the stock and the opportunities will diminish. This became the core of his investing philosophy and over the years he became a legend by picking several stocks in the early stages of growth.
His father was a country doctor. The main interest of Price was to generate superior performance and he believed in doing the best for the client. He started writing articles on investments after he retired from the firm.
He believed that his followers were not fit to succeed him and due to this he had a belief that his firm could not expand after his retirement he thus sold out his share to his associates. The associates offered him an arrangement whereby he would participate in the company’s growth for five years, which he refused. This was one area where he found an opportunity go by as the portfolio under management increased manifold during this period.
Price would look at several qualities before picking a growth stock. This included superior research to develop products and markets, lack of cut throat competition, comparative immunity from government regulation, low total labour cost but well paid employees and at least a 10% return on invested capital. The investor had to develop experience and judgement if they want to pick such stocks. The process involved identifying the industry with a growth potential and then selecting the best stocks in that particular industry.
Price did not believe in predictions for a specific company as he thought it impossible to see what will happen several years down the line to a company. He advocated price earnings multiple approach that is used quite extensively.
BIG MARKET CRASHES
Downturns in the equity market are as old as the market itself and it is not uncommon to find that market crashes keep happening regularly over the years in various stock markets across the world. There have been crashes as bubbles have built up over a period of time resulting in a big fall as things come back down to earth. Some of the big crashes in India happened because of the scams that have taken place simultaneously. Many people attribute a crash to a scam however a scam is not a condition precedent for a market crash and this can happen at any point of time. Many of these crashes will be remembered for a long time to come and here are some of the big and notable falls in history both in Indian and world markets.
THE STOCK CRASH OF 1929 AND THE GREAT DEPRESSION
This was probably one of the biggest crashes recorded in the history of the stock market. The magnitude of the fall and the duration it for which it continued are remarkable.
In developed markets like the US, the period of a bull and a bear market last for quite a long period of time. This means that to go for 7-10 years in a bull market and then a similar period in a bear market is quite common for investors. The period before the fall in 1929 was marked by a significant up trend in the overall prices on the stock markets. Wall Street was having one of its best times in history as economic growth following the war boosted the economy. The crash of 1929 is an example of what happens when panic sets in. Anyone, even remotely related to the market, was impacted in some way or the other. The ripple effects of the fall were not restricted only to the equity investors. The rich and the poor, the old and the young across the US were affected.
After the end of the First World War, the rebuilding efforts began to pick up pace in the 1920s. This time was known as the roaring twenties as industrialisation and new technologies like the radio and the automobile along with air travel began to benefit the economy. Electricity began to be used more than ever before and by 1925 it became second nature to play in the stock market. From 1921 to 1929 the Dow Jones went from 60 points to 400 points. This saw the creation of millionaires and people began to sell off everything else and put the money into stocks. At that time too the use of margin was very popular and this led to a lot of speculation on the markets. The security for the transaction was the security itself so this became a cycle as more and more people entered the market. By this time, the Fed had raised interest rates several times to curb the rising stock market. The boom before the bust became as famous as the bust that followed.
In 1928 itself, there were warning signs that the boom in the economy is coming to an end. But no cared to listen to such voices, as bulls were in full flow. The crash was represented by several mini crashes the first of which began in March 1929. The prices then went on a volatile movement but by September, it became evident that it had slipped to a bear market.
The crash in October saw large dumping of shares as the prices took a severe tumble. In the following years, things only got worse. By November that year, the Dow Jones went to 145 from the 400-levels seen earlier. This gave rise to the great depression where many people lost their jobs and were forced into poverty. One-third of the total population went below the poverty line. In fact, several former millionaires were reduced to paupers.
CRASH OF 1987
On October 19,1987, markets across the world took a severe beating. The Dow Jones suffered a big blow. It lost over 500 points and the fall during the day was over 23%. A similar situation was witnessed across several other markets as the worry grew that the world economy would suffer an impact. Earlier, a large fall was followed by a depression and hence the question was whether this would be repeated.
There have been quite a few explanations given for the crash that occurred on that day. Some people put the blame for the crash on program trading. This is a method whereby arbitrage opportunities were exploited using computers that could make use of the minute differences present in the market.
Another explanation was that it was overvaluation of the markets that led to the sudden crash. The price earnings ratio of the S& P 500 had touched 19 from 10, two years before. The earnings were not keeping pace with this rise and hence there was a feeling that the market was overvalued and the fall was just a way for the market to correct.
Lot of other action happening around the globe also contributed to this fall. There was a spat between Iran and the US on in addition the dollar had been on a decline against other currencies over the last two years, interest rates were also rising in the US since early 1985. US budget and trade deficits were growing. There was also a severe liquidity issue that added to the fall that day as people found it extremely difficult to sell shares. In addition several people also said that the situation in 1987 was similar to that of 1929 before the crash. Each of these events affected the rally in its own way, though none of them could be described as the sole culprit. In the eighties, the US economy was again on the growth path. Wall Street was in the midst of a bull run and things were looking very positive. For a while, the situation was similar to what was happening in the 1920s as the US economy was growing strongly and there was an upward movement in the overall market that led to a big boom in stock prices.
THE CRASH IN THE EARLY NINETIES
The Indian capital market has had its shares of falls, too. Some of them simply refuse to fade away from our collective memories. Quite a few of them have got linked to scams that have taken place in the market. Before 1991, the Indian markets were bound by various restrictions. However, the reforms set in motion by the government of PV Narasimha Rao under the guidance of the then finance minister Dr Manmohan Singh changed the landscape of the capital markets completely in India. The stock market welcomed the idea of the opening up of the Indian economy and the ensuing benefits. It was on a bull run as the government took several steps to liberalise the process. However, soon it became evident that the market was going from one post to the other without even pausing for breath as the index broke its previous levels and kept heading upwards. In the middle of this entire bull-run, there was one name which kept popping up as the person who was leading the charge in several stocks and the name was Harshad Mehta. Nicknamed the big bull, Harshad Mehta occupied the front row in the national media as each one hailed the man, who turned everything that he touched to gold.
Here was a bull who kept taking stocks higher and higher and many of these reached levels that one would have never dreamed off in their lifetimes. However, the market was rising at such a rapid rate and everyone suddenly wanted to get rich quickly and own a part of the shares in the market.
This situation led to people buying shares without any consideration for valuations or doing any research. Then one day, it was revealed that Harshad Mehta had illegally taken funds out of the banking system to play with stocks and use this money to buy shares that rose to dizzying heights. Once this was disclosed, the market crashed and fell to such low levels that left investors holding mere paper in their hands.
Soon this amount was being called back but with the market crashing it became increasingly difficult to sell off the shares and realise the high value that it commanded previously. This led to an overall crash in the markets and investors lost thousands of crores of rupees in the fall in the prices that was witnessed. This was one of first major crashes in the Indian markets.
Harshad Mehta overshadowed the entire bull-run. Such was his stature that thousands of investors went into active buying on hearing that he was interested in certain scrips. Many times, such information was just a rumour but that did not deter investors from pumping money into these scrips.
THE GREAT INTERNET BUBBLE
Every era has its own story of a rise in prices that suddenly seems to rise forever due to a new story or development that will change the world. Sooner rather than later, it often turns into a bubble. For the new generation of investors in the information technology world, this was the internet era when the way one did business changed.
The entire lives of people and the way they lived was expected to be altered as dotcoms became the craze. This became the new mantra across the world as everyone tried to be a part of the great mad rush to create wealth by moving from the physical to the virtual world. In this rush every stock began to command a value that was far greater than what the current financials at that point seemed to suggest. This was because the assumption was that the future would provide an entirely new way of doing business that would lead to a very high profitability. Thus internet was considered as the route that will open up vast riches for the companies and hence the valuations of these companies began to touch the sky even when there was no profit on the books.
This was a period that saw an unprecedented rush towards starting up dotcoms. Soon Silicon Valley became the place to be in as a flood of new ideas dealing with information technology hit the world from all sides.
The stock markets across the world recognised this trend and the valuations of such dotcom and internet companies shot up significantly. This fuelled another round of frenzy as the initial public offerings of these companies made large amounts of money for their investors on listing. At the same time, employees were being offered stock options, which is the right to buy shares and their high values made a lot of them millionaires overnight.
The dotcom era also revolutionised the way in which people began to think and approach various issues. The old way of doing things by dressing in business suits and sitting in meetings gave way to casual dressing. Then people began working from any place at any time during the day. In terms of the stock market, information technology and dotcom stocks were on a major bull run across the world.
However, this continued unabated and down the line there was a disconnect with reality as everything began to be valued at higher multiples in the hope that this will deliver the vaunted pot of gold. Things soon came back down to earth, as there was a realisation that these kind of high valuations would not be possible as the profits that are vital to the companies would not be there at all. The crash then wiped out billions of dollars from the books of investors across the world. Prices in several high flying shares crashed by as much as 90%. Even today, the Nasdaq is nowhere near the highs that it touched during the internet boom. Special allotment of shares by investment banks to their clients and positive analysts reports to increase attraction for these shares surfaced as scams during the aftermath of the bubble burst. A lot of people lost large sums of money in the fall. In the Indian market, a slew of technology funds that were launched during this period sank to prices below their face value and this recovered only after a lot of years.
The period was also linked to the activities of another bull in the Indian markets Ketan Parekh. There were several stocks that were called KP stocks and these reached great heights in the bull run. There were several media stocks that were in the limelight during this period as they reached astronomical prices. It was discovered that funds from the banking system were used to invest in the stock markets. Several banks were impacted and prices crashed.
THE CRASH OF 2004
Indians have been known to look at crashes whenever a scam breaks out and even in those cases there are heavy falls that impacts the markets. There was not anything like the situation that they witnessed in May 17, 2004 when the Indian markets witnessed history being created.
The general elections of 2004 were evenly contested but it was expected that the ruling NDA government would be voted back to power with the BJP leading the charge along with its various allies. The government had been a champion of reforms. The market considered this to be a good bet to continue to story of Indians making their mark across the world. There was a four phase voting and as the phases went on and the exit polls came into the limelight there was an element of worry that began to ripple through the markets as it showed that the NDA alliance might fall short of the magic half way mark in the seats tally. When the actual counting took place and the results came out there was shock and disbelief across the market.
The Congress emerged as the largest party edging ahead of the BJP and this along with its various allies nosed ahead of the NDA. This meant that the NDA would not return to power and the Congress and its allies supported by the Left parties, which had a strong showing in the election would govern the country. Since the position of the Left was not very encouraging as far as market reforms are concerned, there was a worry that this would impact the reforms in the economy.
The markets then fell 800 points in a single day. For the first time in the history of the Bombay Stock Exchange, the 10% circuit filter limit was breached and the market had to close down trading for a certain period of time. There was panic all around as investors sold shares with there being little in terms of buying support for the market.
The market then recovered a bit of ground after the time for the stoppage of trading was complete but it still closed 565 points down that day - a fall of around 11% that was a massive figure by any standards. The next few days as news trickled in that Manmohan Singh would be the prime minister, there was a smart recovery in stocks.
The Economic Times – Stock Market - 2006
