Index fund Investments - Continued

What constitutes the index? How is the index prepared? Why is it required? Is it really efficient?

In this article, I’ll try to give some fundamentals about the index and how it has been changing over the period of time.

A stock market index like Sensex or Nifty is used to capture the behaviour of the overall equity market. By overall equity market, it is implied that the index will reflect the status of the equity market of that particular country. A GOOD index will truly reflect the overall picture of the country specific stock market. Hence, it becomes important that the index is constituted by the so-called BEST available companies.

A mixture of these BEST companies from different sectors ensures that DIVERSIFICATION is taken care of. On any given day, there will be some loosing stocks that will give negative returns, and some winning stocks that will give positive returns. A good index should be constituted in such a way, that it should cancel out the most common positives and negatives across different constituent stocks and come out with a NET value, which can be either positive or negative. If this value is significantly positive, then it is claimed that the country’s equity markets are doing good. If it is significantly negative, it is said that the country’s equity market is doing bad. If the Index value does not change significantly, i.e. stays near about 0% change, it is said to be stagnant. As a general principle, more than +1% or -1% change implies a significant change in market.

How are the stocks selected for index?

There are almost 10,000 stocks listed on BSE. How does BSE decide which 30 should be there in the SENSEX? Or how does NSE decided which 50 stocks should be in NIFTY? This takes us to market value of a company. When a company is listed on the stock exchange, it comes out with a specific no. of shares. Just for an example, let’s say WIPRO listed on the stock exchange with 100 million shares. It means that the company was divided into a total of 100 million parts or what we call shares. Out of this, suppose 85% were retained by the chairman, Mr. Azim Premji and remaining 15% were offered to public. So Azim Premji will keep 85 million shares with him and sell off remaining 15 million shares to public (through IPO). The company is listed, the trading begins and the price starts to change. At any given point of time, the value of the company will be (total no. of shares * Market Price per share). So for Wipro having a total of 100 million shares, and suppose today’s closing price for Wipro was 600 Rs., then the total MARKET VALUE of the company will be 100 million * 600 = 600000 million Rs. The no. of shares usually stays constant (except for some corporate actions), but the share prices change every day. Hence the market value changes everyday.

The exchanges keep calculating the market values of all the companies listed on it. After regular intervals, it generates a list of top 30 (Sensex) or top 50 (Nifty) companies, ranks them in the order of their market value or market capitalization. Let’s take the example of BSE. Let’s say TATA POWER is already in BSE Sensex. However, in the recent market value calculation, if Tata Power ranks 31st or lower, then it will be taken out of Sensex. Another company that will have a better market value will be used to replace it. In essence, at any given point of time, Sensex will have top 30 companies, in terms of their overall MARKET VALUE. It is left to the exchanges to decide how frequently they replace companies.

Have a look at the following changes that have happened in BSE Sensex companies:

Date

Existing Company

Replaced by (New Company)

01.01.1986

Bombay Burmah

Voltas


Asian Cables

Peico


Crompton Greaves

Premier Auto.


Scinda

G.E.Shipping




03.08.1992

Zenith Ltd.

Bharat Forge




19.08.1996

Ballarpur Inds.

Arvind Mills


Bharat Forge

Bajaj Auto


Bombay Dyeing

BHEL


Ceat Tyres

BSES


Century Text.

Colgate


GSFC

Guj. Amb. Cement


Hind. Motors

HPCL


Indian Organic

ICICI


Indian Rayon

IDBI


Kirloskar Cummins

IPCL


Mukand Iron

MTNL


Phlips

Ranbaxy Lab.


Premier Auto

State Bank of India


Siemens

Steel Authority of India


Voltas

Tata Chem




16.11.1998

Arvind Mills

Castrol


G. E. Shipping

Infosys Technologies


IPCL

NIIT Ltd.


Steel Authority of India

Novartis




10.04.2000

I.D.B.I

Dr. Reddy’s Laboratories


Indian Hotels

Reliance Petroleum


Tata Chem

Satyam Computers


Tata Power

Zee Telefilms




08.01.2001

Novartis

Cipla Ltd.




07.01.2002

NIIT Ltd.

HCL Technologies


Mahindra & Mahindra

Hero Honda Motors Ltd.




31.05.2002

ICICI Ltd.

ICICI Bank Ltd.




10.10.2002

Reliance Petroleum Ltd.

HDFC Ltd.




10.11.2003

Castrol India Ltd.

Bharti-Tele-Ventures Ltd.


Colgate Palomive (India) Ltd.

HDFC Bank Ltd.


Glaxo Smithkline Pharma. Ltd.

ONGC Ltd.


HCL Technologies Ltd.

Tata Power Company Ltd.


Nestle (India) Ltd.

Wipro Ltd.




19.05.2004

Larsen & Toubro Ltd.

Maruti Udyog Ltd.




27.09.2004

Mahanagar Telephone Nigam Ltd.

Larsen & Toubro Ltd.




06.06.2005

Hindustan Petroleum Corp Ltd.

National Thermal Power Corpn. Ltd.


Zee Telefilms Ltd.

Tata Consultancy Services Ltd.




12.06.2006

Tata Power Ltd.

Reliance Communiation Ventures Ltd.

Interesting to note the following:

1) Tata Power was in Sensex till 10/04/2000. Then it was replaced by Zee Telefilms. After that, on 10/11/2003, HCL was replaced and Tata Power was back in Sensex again. On 12/06/2006, Tata Power was kicked out again by Reliance Communications.

2) Ballarpur Industries was kicked out of Sensex on 19/08/2006. Till date it is out of Sensex. Same was the case with Premier Auto, Pieco, Mukund Iron and few more.

3) Then there are others like Tata Steel and ACC, which are there in the Sensex since the beginning and holding onto their positions.

Here is the list of changes in Sensex.


Now comes the interesting point: TATA Steel and TATA Power, both belonging to the same business house of TATA’s. Still only one manages to keep itself in index and other is in and out regularly. Other industries of TATA are NOT able to make it to the index. The above 3 points shows how wrong we can be in terms of understanding and differentiating GOOD v/s BAD companies. Ballarpur, Novartis, Mukund Iron, Scinda, Ceat, Peico, etc etc. after being kicked out were never able to make it back again. If you had invested in these companies just by thinking that they are part of index so they are good, you would have been wrong. Though you may have not lost your investment on some of these companies because they are still in business, but you wouldn’t have been able to make the maximum profits.

This also shows how dangerous it is to invest in individual stocks. What has happened to Mukund Iron? Does it still exist? I could not find this stock name on BSE website. Though once a part of Sensex, Mukund Iron no longer exists. If you had invested in Mukund Iron thinking it to be a good company, you would have been in loss. There is nothing called a GOOD Company or a BAD company – it’s just a matter of time during which a company is GOOD or BAD.

How does index change it’s value everyday?

Suppose an index contains two stocks A and B. A has a market capitalisation of Rs.1000 crore and B has a market capitalisation of Rs.3000 crore. Then a weight of ¼ is attachd to movements in A and 3/4 to movements in B. This is known as weighted averaging and is calculated as follows:

Total of two companies: 1000 + 3000 = 4000.

Weighted average of A = (Value of A)/(Total of 2 companies) = 1000/4000 = ¼

Hence, if there is a 10% increase in A and a 5% decrease in B, the index value will change by (+10%)*1/4 + (-5%)*3/4 = -1.3%.

Hence, the higher the value of a company, the higher it’s power to affect the index value. The same calculation can be extended to 30 or 50 stocks and similar calculations are done for every single price change in the constituent stocks of Sensex, Nifty or other indices. This shows the benefit of investments in Index. A big mixed group of companies mean that the fluctuations are less, negatives get cancelled by positives and you always go with the market.

Are Indices Efficient?

Well, that depends upon the exchanges that constitute the stocks comprising indices and how frequently they change them. The more frequent, the better. Overall, the indices are efficient, as they give the picture of the top companies in a market at any given point in time. When you invest in an index, you simply bypass the problem of stock selection and the problem of a particular stock going out of business or turning out to be a loss making stock. The efficient index will someday or the other kick out the bad stock from it, and replace it with a better stock. The market usually perceives these changes as positive, as new better company is used to replace the old bad company, and the index value rises slightly with every change announced by the exchange.

Can I buy 30 different individual stocks listed in BSE? Will that be efficient?

As far as buying is concerned, yes you can do that. But that is not efficient. The reason is that you will have to pay big amount of brokerage to buy the 30 different stocks. Your demat account charges will also increase with more nos. of stock holdings. Secondly, when a particular stock is included in index, it is taken as a positive sign, and price rises immediately. When a particular stock is kicked out of Sensex, it is taken as a negative sign, the price falls sharply. So, by the time news reaches you and you act on that, you will end up buying a high price stock, and at the time of selling, you will have to sell it at a lower price. Can you hold it for a long period instead of selling it? Yes, but then what is the guarantee that it will give you good returns? Remember Mukund Iron, Peico, Premier Auto, discussed above. No guarantee for anything.

On the other hand, when you buy the index or an index fund, you simply buy it as 1 single stock, instead of 30 stocks or 50 stocks. You pay brokerage only on 1 particular trade and hold only 1 particular stock in your demat account. Hence, it cuts severely on the brokerage and demat charges. At the same time, it benefits you with diversification.

So is it that index or index fund investment is always efficient?

Well, not necessarily, and not always. It depends upon your investment style. There are risks associated with index investments as well. If it had been a fool-proof investment strategy, everyone would invest only in index and not other instruments. However, it is far far better than the individual stock trading backed by error-prone stock picking.

Also, Index investments are also prone to the market risks. Let’s discuss the risks associated with the index investment and the available index investment options in India in a following article.

The Simplest Investment Strategy

Over the past few weeks, I've tried to give an insight into the market. Received with severe criticism from a few and some greater expectations about the so-called efficient investment strategies, I think it will be nice for me to put up something on the investment side, much before I'd planned.

Some individuals have left comments that they are following principles led by Warren Buffet. Others proudly claim that they can take risk and are ready to loose money in the market following “No Pain, No Gain”. Fair enough.

It’s easy for anyone to look on Warren Buffet on internet and get his principles. It’s exciting to read that “Warren Buffet bought his 1st stock at the age of 11, and still he feels he was too late to begin stock trading”. OR we watch movies like GURU, where Abhishek Bacchan delivers the dialogues “Mein ek BANIYA hoon aur baniya dhandha hi karta hain” meaning “I am a Businessman, and a businessman is there to make business”. It’s easy to get carried away when you read/hear such things. Rest environment is created by the peer pressure, so called smart traders who are our office colleagues trading online. We are ready to take the risk, claiming that we will NOT regret the losses, if any. Unfortunately, the more we loose, the more we get a tendency to gamble, attempting to recover our losses. Once again, markets go up, everyone makes money and feels happy and pours in more money. Market go down, we loose, and invest more by trying to “Average out” our holdings and trying long term strategies. It’s an addiction. What we fail to discover is that Warren Buffet has ALSO advised youths not to ever use a credit card, and never to take a loan. If a loan is taken, he suggests better to pay-it off first, before getting into the equity market. Another interesting fact that is NOT very well known about Warren Buffet is that he has NEVER invested in a technology company or so called IT firms. India’s heart and soul is the IT workforce.

The reason for me consistently talking about the way the market and the market participants work, the comparison with the Market Index and the failures of MF managers was not just by chance. I was planning to approach the topic in a much more structured way. Though it is too early for me to express and detail the investment scenario, looking at the way the readers are fighting on the comments, I'll go ahead with it to give an introduction about investments.

I've always compared the individuals profit with the market index returns. The reason - Markets are efficient, and so are the market indices. People end up doing all kinds of research to hone their STOCK PICKING skills. Frankly speaking, there is no need for anyone to pickup the stocks. The market index itself is a very good selection of the top rated stocks. Be it NSE Nifty (top 50), BSE Sensex (top 30) or Nifty 100 (top 100), Nifty Junior (top 51 to 100), all these indices carry the top rated companies, in terms of the market valuation. The stocks contained in these indices are reviewed from time to time by the exchanges and the relatively non-performing stocks are kicked out from the index, while new ones are included to replace them.

What constitutes the index? Basically a fixed no. of stocks – 50 for Nifty, 30 for Sensex. Why are the indices always kept upto the mark by the exchanges? Exchanges like BSE and NSE are organizations. They compete with each other, and other regional exchanges as well, so as to get maximum transaction business. When you place your order with your broker, he forwards it to the exchange. Broker needs exchange membership to place you orders on the exchange and have to pay the transaction fee to the exchange. To get the exchange membership, he also needs to pay fee. Ultimately, the more transactions happen at a particular exchange, the more business it generates. The more brokers are subscribed to an exchange, the better its order capturing business. It’s also a requirement for an exchange that more and more companies get listed on it. For e.g. IQMS Software is listed only on BSE, not NSE. Anyone wanting to trade on this stock can do it only on BSE, that too with a broker having BSE membership. It becomes a requirement for exchanges to list the best companies (BEST atleast in the way the exchange measure them). At the same time, they also need to give market indicators like different indices, which give how the markets are moving. These indicators are tracked by market participants, to know how the markets are moving. Hence, exchanges need to keep themselves upto the mark, with the best companies constituting the major indices. They have to review the constituent stocks at regular intervals, so that they can get the best market picture at any given point of time.

What happens when you begin trading/investing? You begin trading/investing by purchasing 1 stock.
If you make profits, you can do 2 things:
1. You may sell the stock and get the profit. But what do you do with that money? You tend to buy another stock.
2. You may not sell the stock, but get excited about the unrealized profits you made on your first investment. You tend to buy another stock or more quantity of the same stock by putting in more money.

If you make loss:
1. You tend to average out by buying more stocks
2. You buy another stock and start talking about diversification

The fact is, ultimately you start to increase your holdings constituting a portfolio. You start talking about diversification, stock-picking, sector-wise allocation, and so on. Ultimately, you never come out of the market. If you make profits on your portfolio, you keep the stocks as it is and keep buying more stocks OR you book profits and use that money to buy another stock. If you suffer losses, you end averaging out, or in a tendency to recover your losses, you pump in more money. The BUSINESSMAN inside us never allows us to completely exit from the market, whether we make huge profits or suffer losses.

However, instead of going through all this headache process of stock-picking, diversification phenomenon, isn’t it a good idea just to invest in the market index like Sensex or Nifty? The exchanges are always upgrading the constituents of the index. They do the stock-picking for you for free. The index has all the constituents that are well-diversified across different sectors. That is the reason the index (Nifty or Sensex) only goes a maximum of 1% up or down on a daily basis, while individual stocks fluctuate with a much higher value. Investing in these indices provides us with a much less risk, as they are already diversified and have the so-called BEST companies as their constituents.

You may now say that I’m contradicting my previous 3rd article Good Company v/s Bad Company. Well, I’m not. The case with index is different. If a Good Company listed in the Index turns out to be a Bad company, it is kicked out of the index. The index value hardly suffers 0.1% to 0.5%, sometimes it even rises, as the new incoming company may be well appreciated by the market. The another so-called GOOD company is brought into the index. Hence, without you actually having to worry about good and bad companies, you can easily get the implicit benefit of stock picking.

In my first article Are you really making money in the stock market, I started with comparing the returns with respect to the market index (Sensex or Nifty). If you had invested in indices instead of individual stocks, you would have earned a whooping 600++ % returns, without having to worry about stock-picking and all kinds of crapy non-sense.

In my second article, Do equities give good return in the long run, I tried to refute the 2 commonly believed myths about bonds and equities. One thing that I want to stress here is that I’m not against equities or bonds. I’m for systematic investments which may include both. The World Equity market is estimated to be at 45 Trillion $, while the exchange traded bond market is about 51 Trillion $. Approximately 60 Trillion $ is the Over-the-counter bond market, that makes the bond market more than double the size of equities market. It shows the importance of bonds. If equities had been the only way to beat inflation and give better returns, bond market would have collapsed by now. The fact is that it is more than double the size of the equity market.

In my 4th article, Should you trust you fund manager, I questioned whether it is worth paying the commission to someone else to manage your money in the name of professional management and diversification and can you be better off in doing it yourself if you know the problems and have alternate investment mediums? The problem with MF managers is that they have to buy and sell stocks, to try and make returns. They end up paying transaction costs which comes from your pocket and eats up the profits made on your investments. Another problem is that a fund like Reliance MF, which managed to gather 5820 crores of Rs. recently, has to invest this big money somewhere. They cannot limit themselves just by buying 30 stocks of Sensex or 50 stocks of Nifty, as the amount of money they have is huge. So they end up buying loads of other stocks, which eat away the profits in transaction costs or loss making stock selection.

In my 5th article Equity research analysis and recommendations, I tried to highlight how our investment decisions are manipulated, and whether it is worth paying for advisory services to your broker or using free advice available online.

In my 6th article Stock Trading Markets, I tried to publish the picture of the market for intraday traders and news based trading and how it fails miserable for we salaried professionals.

Now all the above articles were supposed to be the foundation stones for one of the investment strategies that I have presented in this article. My focus was to highlight all the problems and drawbacks with all the available modes of investments, products and sources and then present the investment technique which atleast partially eliminates the problems that I’ve been discussing in the previous articles. Probably, it’s the human nature; the businessman inside me does NOT have the patience to understand the problems, and then approach the solution. It only needs the solutions straightaway, and want immediate results, irrespective of knowing how and why the solution is better than the rest. Not sure how many of you will still agree with me, but I believe that atleast for people who agree with me, this will be a good start to continue further.

You will definitely have questions about the risk involved, transaction costs and other problems that are there with Index investments.
How to invest in Indices or Funds replicating the indices, and also info about the risk associated with these, please wait for further continuation on this article, which will be published shortly. This one was an attempt to stop the COMMENTS WAR that is going on among the readers of this blog :-)

Here is the article with example and historical data for ETF

The Stock Trading Markets: Traders and Market Makers and Individuals

A request for people who are reading my articles for the first time: Please start reading the articles in chronological order – First article First. This will ensure that the concepts presented here are easy to grasp and the continuity is maintained.

It has been sometime now, and I’ve published a few articles. Some were well appreciated; some were criticized with claims from individuals about how they were able to make good profits from equities. Anyways, I tried to prove with calculations and historical facts that it is really difficult to consistently make money in the market.

However, no one ever pointed out a very commonly observed fact: How are the traders & market makers - who are either working for investment firms or doing trading for a living – how are such people able to survive? How do the ones employed as traders at investment firms able to keep up their job, and how are the ones who are trading for a living manage to earn a livelihood. Well, the fact is that they do make good handsome profits, and they do manage to keep up their jobs and livelihoods.

The concept of EFFICIENT MARKETS: This is a famous story about two finance professors who were walking on a street. Suddenly, one of the professors says to the other, “Wait, I think I saw a 100 Rs. note lying on the street a few yards back”. The other professor stops, thinks for a while, and replies, “It’s IMPOSSIBLE. If there had been a 100 Rs. note lying on the street, it would have already been picked up by someone.”

Actually, what is implied by the above short story is that there are NO FREE MONEY opportunities anywhere in the market i.e. no one can get money for free. If there are free money opportunities, they would already have been utilized by someone else – either as a whole or in bits and pieces. “No free money” is equivalent to NO FREE LUNCH – as commonly heard in the corporate world.

Continuing the explanation for the story above – let’s say you are walking with a friend on a lonely street. Suddenly, you see a few 1 Re. coins lying on the street. Immediately, you and your friend start collecting the coins. Let’s say there are a total of 100 coins lying on the street. Assuming equal efficiency of you and your friend for collecting coins, and each of you take approximately 1 second to collect a coin, then the total 100 coins will be collected in 50 seconds – 50 by you and 50 by your friend. Now, if instead of only 2 of you, let’s say you are walking in a group of 10 friends, and the group spots the opportunity to collect 100 coins lying on the street. Assuming same 1 second collection ability, each of the people in the group will collect 10 coins, and all the 100 coins will vanish in just 10 seconds. Extending the group size to 100, the coins lying on the street will vanish in just 1 second –with each individual pocketing 1 coin, on an average. For 1000 people, only a few will be able to get the coins – some may get more than 1, majority of them will get none. Assuming that coins are divisible, in most of the cases, 1 single coin may be shared by many individuals.

This is exactly what goes on in the markets. The moment there is any news of profitable opportunity, the BIG SIZE of market participants ensures that the profit making is done immediately. Around 2-3 years back, Balaji Telefims (The Saas-Bahu serial TV Company led by Ekta Kapoor), was trading at Rs. 105. It declared a dividend of 16 Rs. a share. Within 1-1.5 minutes the price of the stock reached 121-122 Rs. I acted on this news an hour later and purchased the shares at 122 Rs. After the dividend expiry, the price fell back to 102-103 levels (later even to 85 Rs.). I got the dividend, but I got nothing better than the market price, instead I paid more than the market price after the ex-dividend date. Anyone trying to make profitable trading on such news will have to remain alert and keep a vigil on every single news item that comes out. Not only that, he should also be fast enough to act on the news and place the trades to book profits. Can we individuals do it?

We should understand and realize this fact very well, that the market is full of market participants. Any piece of news, any information that is publicly made available, is utilized immediately in the market. No body can be sure of making exceptional returns in the market by utilizing the publicly available information – In essence, the MARKETS ARE EFFICIENT – which means any news that affects the price of stocks, is IMMEDIATLETY REFLECTED in the stock price (with a change in stock price).

I see people reading Economic Times, Business Standard and Business magazines. They watch business news channels, CNBC, Zee Business, NDTV Profit – all attempting to extract valuable information to take profitable positions for trading or investments. Ultimately, they fall victim to the Efficient Market Hypothesis. They end up buying stocks which are already having the effect of the news included in the stock price. The news can be anything –Company bagging orders worth crores, company declaring a dividend or stock split or other corporate action, company declaring handsome profits, etc. etc.

A colleague of mine acted on a stock split news of a penny stock: IQMS Software. The stock was trading at around 8 Rs. when the news of 1:10 stock split came in. Immediately, the price started to increase and touched a high of 13 Rs. My friend bought this stock in big numbers at 11 Rs. After the stock split, the price had changed by a factor of 10, i.e. his buy price of 11 Rs. was now Rs. 1.10 and the no. of stocks he bought was multiplied by 10 times. He invested a total of around 1.5 Lakh Rs. for purchasing this stock. However, after the split, the stock price started to decline, touched a low of 0.36 Rs. and as of today, it is 0.75 Rs. My friend is waiting since last 2 years just to recover his money. The stock has never made to his buy price of 1.1 Rs.

Let’s take a very recent example of Tuesday 29th May 2007. Indian stock markets went down by around 1.5% -which is a significant decline in the overall market. The reason – China increased the stamp duty on stock trading by 3 times – from 0.1% to 0.3%. Could someone please tell me what has the Indian market to do with Chinese trading charges? At the end of the day, the CNBC Indian Business Hour tells the reason that “Asian markets were affected by Chinese decision, so the Indian markets went down”. Fair enough – what can we individuals do with such news and how much can we benefit from such news – only God can tell. Everyone can give justification for what has happened in the past. Declaring something for future is a dangerous task. Next time will you sit and watch the news coming from China? Thailand? Vietnam?? Definitely not.

Coming back to what I mentioned in the initial part of this article – traders and market makers making profits. They make profits because they have to – otherwise they will not survive. They have to act on every piece of news and take positions accordingly; else they will be out of business in no time. That is what affects the market. Hundreds of such traders, working either individually or employed with investment firms – keep making the trades on every single news item. They loose money, they make money. At the end of the year, they have to show a net profit; else they are shown the door. A typical trader employed at a reputed investment firm gets a fixed salary of around 9-10 lakhs per annum. However, his performance bonus can be as high as 500% of the annual salary, i.e. 50-60 lakhs – solely dependent on the profits he makes from his trades. In 2003, a friend of mine, MBA in finance from top grade management institute in India, employed at a reputed investment firm, had an annual salary of 12 lakhs. He made a handsome profit and got a bonus of 60 lakhs – making it a total of 72 lakhs! However, the next year he suffered losses. Immediately, he was issued a warning from his boss – signaling an exit from the job. He switched the job and today, he’s happy as a consultant with a consulting firm based in Mumbai, paying him a CTC salary of 14 Lakh. You ask him about becoming a trader and his response will be – “It’s a dirty business, stay away from it”. The same will be my response to someone asking me a similar question. The investment firms usually always show profit, because majority of their profits come from brokerage and other deal making commissions. Coming to trading side, at any given time, there will be some traders making money, some loosing money. Even if there are net losses from the trading activities, it will be compensated by the brokerage profits. Winning traders get a share of the profits they make. The loosing traders are kicked out of the job after 1 or 2 warnings, new ones are recruited to replace the loosers and the game continues.

As Mr. Taleb has rightly mentioned in one of his interviews – “If you put enough monkeys on typewriters, one of the monkeys will type a word which is grammatically correct, just by chance. But would you bet any money on the same monkey that he's going to write another correct word next? Definitely not! You know that because of the sheer size of the sample, you're likely to find a lucky monkey once in a while. But will he be able to show consistent performance?”

The same applies to the traders – profits in one year do not guarantee profits in another year. Even they fall victims to market activities and randomness. The moment traders find they are in a loss or have received warnings, they get the signal – either they switch jobs to other investment firms or change the stream (like my friend did). Overall, the common man sees only profits of the firm as a whole, primarily coming from brokerage commission or advisory services on M&A deals or similar transactions.

Then how about the people who are trading for their own living or traders who are consistently making money and are employed within the same firm for years? They have to trade within a very tight profit margin – say just 0.1% to 1% levels. Then how do they make money? They have to trade very frequently, sometimes buy and sell within a minute! They trade with big capital and multiple times. Huge trading volume ensures lower brokerage charges, and multiple profit opportunites (along with the limited losses). These people are experienced and educated enough to know what they are doing, how they have to do it and what implications their trading actions will have.

What’s in it for individuals like us – basically, NOTHING! The reason I mentioned all these details above is to give you a picture of the trading world. We individuals, employed as salaried professionals or running our own business/shops, cannot keep up our trading activities like the professional traders – nor do we have the knowledge, capital and professional experience to control our losses and make smaller profits multiple times. When we trade, we are pitted against these professionals, who are making the markets. We all fall victims to the market trading activities – majority of the times making losses in intra day trades.

It’s a highly efficient market; acting upon news is nothing more than fooling ourselves. Either stick to your actual job/profession and be sincere to it or become a fulltime trader – Nothing in between will work as far as the trading activities are concerned.

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Equity research, Analysis & the recommendations

A request for people who are reading my articles for the first time: Please start reading the articles in chronological order – First article First. This will ensure that the concepts presented here are easy to grasp and the continuity is maintained.

Yesterday, I got a comment from Mahen, which is just in time with regard to this new article of mine. In his comment, Mahen has mentioned that “Most of the analysts are BULLISH on India, basically believing that Indian Success story will continue atleast for next 5-10 years, so it is worth investing in Indian equity market”
He is right, atleast about what the analysts say - 99% of the analysts are bullish on the Indian story. But who are these analysts???

Let me explain this - Every investment firm (Mutual Fund, Investment Bank, Brokerage Houses, Security Trading firms, etc.) has a dedicated team called equity research team. The members of this team are called equity research analysts - or in short "Analysts". These people try to keep track of the companies and their performance. They try to look at the CASH FLOWS of the companies and apply valuation strategies like “Discounted Cash Flow” techniques and try to calculate the future value of the stock. Following their "ANALYSIS", they arrive at a stock price which they believe is correct as per their valuation. If the Market price of the stock is lower than their calculated stock price, they give a BUY recommendation for that stock, means they think that at the present market price the share is cheap, and it will rise to its fair value (the value that they calculate). If the Market price of the stock is higher than their calculated stock price, they give a SELL recommendation for that stock, meaning the share is over-valued so sell it off, otherwise it will come down to it’s fair value.

But to whom do they give these recommendations? They work for an investment company, so obviously the recommendations are given to the other teams within their company so that they can benefit from their analysis. These recommendations are given to their Fund Managers and the traders of the investment firm. The Fund managers and traders look at the “Research Analysis” or “Research Reports” from these “Analysts” and take action accordingly. Along with these research reports, they also use their head, and take the decision of buying and selling as per their understanding. Sometimes, these research reports are offered to public for free. These analysts also predict the results of the company – viz Sales, Profit, loss, taxes, etc. each quarter.

The question is: Can these analysts be trusted? How solid is their research? Is the valuation method they follow robust enough to calculate the price accurately?

The answer is NO. Take a recent example. Reliance Industries, one of the most reputed Indian companies, before declaring its results, called for a analysts meeting. Analysts from reputed Multinational Investment firms and trading houses were invited to the meeting. They estimated reliance profits to be at a value which was much lower than the actual one. Reliance shocked them with a staggering 40% higher profit than what the research analysts had calculated. The result – immediately after the results announcement, the stock price of reliance started to increase. From the level of 1350 or so, it is now at 1700 level. This is a very recent example which shows how the research analysts fail.

Doing such research is a very subjective task: Analyzing a company means understanding its projects, understating how much investment is needed and for how long the project will run, understanding how much profit it will generate and from when, predicting how will the market respond to the product from that project, estimating market risks in terms of competitors entering the market and when, interpreting whether the project will run in foreign countries, what about currency fluctuations, etc, etc, etc, etc. You see, the list is endless – but the list contains all kinds of “ESTIMATIONS, INTERPRETATIONS, UNDERSTANDING” and similar highly skewed terms. These methods are highly error-prone.

Companies are required to publish their business results (Sales/Profit/Loss/etc) every quarter. Just before the company is about to declare the results, the analysts calculate the value of the company by trying to estimate the sales/profit/losses/etc. You may have heard this term quite often: “XYZ Company beats street expectation OR ABC Company failed to beat street expectations”. The term street expectation is a value calculated by these analysts. These analysts give their expectations about the company financials just before the declaration of the results – called STREET EXPECTATION. If the actual results of the company are better than this value, it is called “Company beats the street expectations”; otherwise “Failed to meet the street expectations”.

This brings us to another fundamental situation – why will someone give a recommendation on a particular stock, a particular industry, a particular market (means a country)? Visit the stocks section on Rediff website: http://money.rediff.com/money/jsp/markets_home.jsp. Just below the Sensex Chart on the right side, you will see a section called “Broker Tips”. At the time of writing this article, it had the following table:

Broker tips

Broking House

Company

Action

Date

Price

Sharekhan

+

Intl. Combustion

Buy

Jun 05, 07

519.00

Emkay

+

Tata Chemicals

Buy

Jun 05, 07

279.00

Macquaire Research

+

Punj Lloyd

Outperformer

Jun 05, 07

263.00

IndiaInfoline

+

Nagarjuna Constr

Hold

Jun 05, 07

182.00

Khandwala Securities

+

NTPC

Buy

Jun 05, 07

172.50



Basically, the brokerage firm, like ShareKhan, is giving a BUY recommendation on Intl. Combustion for buying at a price of 519.00, and similarly there are other tips. Similar tips and recommendations can be found on websites of other brokerage houses and investment banks (including MNCs), all available FREE OF COST.

The recommendation is coming from investment firm – my question is why these firms are telling OTHERS their investments tips? They have done the research, they have invested their time, effort, money and energy in coming up with the research report, so they should use it for their benefit. These firms have enormous amounts of money, why don’t they invest the money for themselves, why are they telling it openly?

Imagine what would you do if you buy something – say a stock or some crop or some other goods - which you decide to sell later at a higher value to make profits. What would you do, you will start spreading all good things about the stuff that you’ve bought. You want the price of that to increase, which ultimately happens if the demand for that stuff increases, which will happen if more people know that this stuff is good. The same thing goes on in the finance world. The investment firms that give recommendations are for the stocks that they have already invested in. They want the price of that stock to go up – so they give a BUY recommendation. People who believe on them, start buying the stock, the demand goes up, so does the price. The investment firm then sells off its holdings at a higher price, and makes good money. The investors, who buy this stock at higher price, then have to wait, claiming that “I’m a long term investor, in the long term, this stock will appreciate”; sit back and relax.
The opposite happens when an investment firm wants to BUY a stock. They issue a SELL recommendation. The investors who believe them start selling the stock, the supply rises and the prices fall. The investment house then buys the stock at a lower price. And the game continues.

The basic fact for research and analysis is: If I know something is good, why will I tell it to others? I will tell it to others only to get the benefit for sharing the secrets publicly. The way it is done is explained above.

These were the same analysts from reputed investment firms- who could not predict the internet bubble burst in 2000. Forget about 5-10 years long horizon, the analysts were giving BUY recommendation on every single dotcom stock in 1999 – claiming it to be a multibagger. Within a year, in 2000, all the dotcoms went burst. In India, television started gaining popularity since 1985. Analysts predicted it to be the end of the radio industry. However, after 20 years, radio industry in India is bouncing back significantly, such that majority of the mobile phones available today come with an inbuilt FM radio. Did anyone get a BUY recommendation on media stocks before the onset of radio industry? The answer is NO. Did anyone give any recommendation on the airline stocks before the consolidation started happening in the Indian Airline Industry – NO. Did any analyst give a SELL recommendation on Infosys stock in 1999 just before the slowdown in the IT industry – NO. Did anyone predict the strength in Indian Rupee against the dollar and gave opposing recommendations for Oil companies (ONGC, HPCL, etc.) & IT companies (Infy, Wipro, Satyam)? Did any analyst give recommendation in the fall back in Real Estate sector due to rising interest rates? Sometimes they do, but by the time the common men takes action on the advice, the action has already happened, the price significantly rises/falls and all the individual is left with is a loss making investment.

A very simple example can be quoted here: With the advances of medical science, people are living longer. When they live longer, there is a need for medical facilities. Isn’t this reason sufficient for a LONG TERM INVESTOR to buy pharma and hospital stocks? If this is a simple and robust reason, why don’t the fund managers keep significant portion in pharma or hospital stocks? The fact is that innovation and consolidation keeps happening. Technology moves at a rapid pace: A magic drug manufactured today can be out of the business (and its pharma company) within no time, if another better version is developed by a competitor. What prediction can anyone make about the development, research, advancement, market response, competitors product of a particular company or industry. All the task that analysts do is either look at PAST results (balance sheet of the company) and give FUTURE recommendations OR try to GUESS the project cashflows, and make predictions. How correct they are – merely depends upon their luck. Who ends up being a fool are the people who become victims of their recommendations.

Coming to the Indian story, let’s look at it from the root level. If you are believing the comments on the Indian story, it is mainly driven by the middle class salary rise. All are aware that this rise is mainly constituted by the IT sector – how long can people in Indian IT sector keep their jobs? Already, companies like British Energy have scrapped their BPO operations in India and taken back the work to their own country. A very honest article about the reality and trustworthiness of the GREAT INDIAN IT INDUSTRY is available at http://in.rediff.com/money/2004/mar/03guest1.htm How long will the Indian story continue, no one knows. Even Indian companies like Infy, Wipro, Satyam have opened up offices in China, Russia, Romania, Czech Republic, Canada, Philippines, Thailand, etc. If the work can be outsourced to India, it can as well be taken away to another country. It took only 2 years for outsourcing to become a buzz word; it may take much less than that for the work to be taken away. At that point of time, there will be no rising salaries, no spending power, no extra money, and hence no demand and affordability for new houses or cars or visits to shopping malls. When will it happen, no one knows, but if it happens, things will come done tumbling. The great Indian Software engineers proudly submit their pay slips, take house loans, car loans for big amount – completely missing the crux of the point that everything is dependent on their salary, which comes from a HIGHLY RISKY job. If they loose the job, they loose their salary, they loose their house, car, everything. You talk about boom in real estate, or boom in the retail market, or hike in car/bike sales, all coming from the extra spending power from the emerging middle class-which is driven by the software salaries. Sometimes I wonder what other job a software engineer can take up if unfortunately he looses his job. Everyone is relying on the Indian Story, mainly dependent on the foreign money from IT industry – how long it will continue, only time will tell. Rupee-Dollar rate has already hit the IT sector, same is being reflected in other sectors as well. We’ve already seen the slowdown in Indian IT sector in 2000 to 2002 period; still people don’t realize the ground realities. It’s a risky job and a risky Indian story, plan your finances properly and especially your investments. More on personal finances in a later article.

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Should you trust your mutual fund manager?


A request for people who are reading my articles for the first time: Please start reading the articles in chronological order – First article First. This will ensure that the concepts presented here are easy to grasp and the continuity is maintained.

A number of people have contacted me asking whether they should invest in mutual funds and what are the risks associated with a mutual fund. Well, most of the people are well educated about mutual funds so I’m not going to list the advantages (diversification, professional management, etc.) and disadvantages (market dependency, historical return do not guarantee future returns, etc.) of the mutual fund investment. You can find a lot of articles that talk about them, majority of them available on finance websites, primarily talking only about the benefits of Mutual Funds, as most of the articles are written by financial experts who work for finance companies and want to earn handsome commission for selling more units of their fund. Majority of them can be found on sites like rediff.com, moneycontrol.com, personalfn.com with jazzy titles like “Invest 10,000 now to retire Crorepati” or “Save big on tax by investing only 10K”. These articles carry some data tables, showing how an investment in so and so scheme could make you a crorepati by the time you retire, or how much tax can you save if you get into a Insurance plan for 25 years. The website at the end of the article, puts up a disclaimer saying that views expressed here are of the author and website does not take any guarantee for investment based upon the suggestions. Same thing goes with the advisors who come on Business News channels. Such articles with these flashy titles but highly inaccurate data serve multiple purposes:
• Jazzy titles make a person click on the link. This adds to the website revenue, by showing ads – More profit as more people visit the pages
• The Author or the so called “Investment Expert” or “Certified Financial Planner” gets to promote his concept (basically his product- Insurance scheme, mutual fund) to millions of people
• The website adds a message board at the end of each article – Visitors start publishing their “intelligent comments” and fight with each other over what is better or worse, what is wrong or right with the article, what is the best investment strategy and so on. All this results in millions of webpage hits: Net result – pretty good profit for the website, which is also shared with the author.
• Now a days, the authors also provide their email address, so that people can contact them directly. The psychology that works here is as follows: People believe the author is a real expert – that’s why he is able to publish his articles on reputed websites, so they contact him for his expert advice and the response that comes in is for an advice to invest in that particular scheme. I tried contacting a few of such authors pointing out mistakes in their calculations in their articles. The response I got was not answering my questions, but “XYZ scheme is very good and reliable, please invest in that, you will definitely make good money”.

You may be wondering what is the reason I’m quoting all these things here, and how do they relate to the title of this article? Well, I’m attempting to establish the link on how an investor’s decision is influenced, given the free and easy access to information/advices on internet and television.
Why is the Mutual Fund Manager interested in managing your money? If he’s such an expert, why doesn’t he keep the money making secrets with himself and keep trading for himself making great profits. Obviously he’s not doing it for charity. You have to pay him a commission- that either comes in the form of “Entry Load” and “Exit Load”. This is the commission that also pays for the advertisement of Mutual fund and payment to various agents who are willing to come to your office/home to fill up the forms for you and take the Cheques for investment money –all services appear to be free with home delivery.
Usually, when a fund comes into the market, it comes through NFO or New Fund Offer (equivalent to IPO for stocks). People subscribe to it by investing their money. For any mediocre fund, it is not difficult to collect around 800 crore rupees from the market. Established fund house like HSBC managed to gather as high as 1700 Crore Rs. for their single fund in 2003. The mutual fund manager takes a percentage of this collected money as his commission to manage the fund. It usually lies in the range of 1.5% to 3%. Now, for a very mediocre fund that collects 800 Crores from the market, the fund manager at a rate of 2% takes home a whooping 800 *2% = 16 Crore Rs every year! The remaining amount of commission collected in the form of “Entry/Exit Loads” is used to pay to the agents and for advertisement and promotion of the fund. In essence, everything comes from your pocket. If you see a full page ad in newspaper for a Mutual fund you’ve invested in, it is you who has paid for it.
Each of these ads, either on TV or in newspaper, carries the famous tagline: “Mutual Fund investment are subject to market risks, please read the offer documents carefully before investing.”

So now, when the fund manager is pocketing such a huge amount of money (16 crores each year) even for a mediocre size fund (800 crores), why is it that he CANNOT guarantee even a 1% profit? Forget about the profit, he cannot even guarantee the protection of your principle amount that you give for investment in MF.
The reason – Having decades of experience in the market, the fund managers (and all the mutual fund companies) know the dangers of stock markets. They are well versed with the risks, downturns and the panic periods that may come anytime. They know that markets work randomly, their direction is unpredictable. The regulatory authorities like SEBI, also know the risk in stock market investments, so they have implemented this legal requirement for mutual fund companies. Recently, you may have heard a lot of controversy over investment of Provident Fund money into stock market, which is opposed by many politicians and economic experts. Its due to the same reason, the government has the liability of Provident Fund money, it does not want to suffer losses if the PF money invested in the stock market going for a toss. That’s why there are proposals for only a small percentage of PF money to be allocated to investment in stocks.

Now I want to ask the same question to people who claim to make 15-20% profit on their individual investments in Stocks. If the Fund Managers and Companies with decades of experience cannot guarantee even the protection of your principle amount, where do you stand when you say that you can make 15-20% profits year-on-year? What is the basis of your justification and calculations?
Then, some of you claim that a minimum 15-20% annual profit is guaranteed if you invest in the so-called BlueChip companies. I’ve already attempted to prove that we cannot differentiate between good and bad companies in a previous article. However, if you as an individual are so sure of making even atleast 10% profits by investing in so-called bluechip companies, then even the fund managers can invest in the same bluechip companies – still why they do not guarantee anything? The reason is same – highly uncertain and unexpected market behaviour at unexpected times even for the so-called blue-chip companies.

This also takes us to question for another commonly heard term – diversification and asset allocation. One of the major benefits of mutual funds is diversification which eliminates the risk of putting all the eggs in one basket. Asset Allocation is also linked to the same concept of diversification, additionally it takes into consideration the percentage money allocated to different stocks in the portfolio. Even a small size mutual fund will have a MINIMUM of 60 stocks in its portfolio at any given point of time. Now, when the mutual funds have this diversification and asset allocation as one of the major plus points with them, why still they cannot guarantee any profits?

Mutual Funds also give the advantage of PROFESSIONAL money management – which implies that educated and experienced professionals take care of your money. However, still the question remains the same – why no guarantee of profits?

I usually do not present anything without facts: So let’s have a look at the performance of fund managers (Stock-Equity Funds) over the period 1986 to 1995, as compared to the rise in the market. (Graph at the begining of this article – You may open the graph in a new window for better viewing).

The graph shows how much the returns generated by the fund were LAGGING behind the returns generated by Market Index during each year. For e.g. in 1989, if the Market Index (S&P 500) made 100% profits, then the equity funds for the same period were lagging behind the market by 82%, i.e. the equity funds made only 18% returns as compared to 100% returns from the market. If the market went up by only 10%, then the equity funds produced only a 1.8% profit. Even in the best case, in year 1993, the graph is showing only 40%, which means if the market went up by 100%, the equity fund went up only 100%-40% = 60%.This was the best case scenario with respect to the equities fund. The most IMPORTANT of all: The last bar graph shows a summary of entire duration 1986 to 1995 – indicating that during the overall 10 year period, on an average the equity fund could manage only 100%-80% = 20% returns as compared to a 100% market returns.
Obviously, if in any year the market went down, the mutual fund was down further with much bigger losses.
One thing to note here is that the performance calculated above was not for any particular fund, but the average return generated by all the available equity funds was taken into consideration. As of today, there are more than 3600 funds available in India alone (Source Association of Mutual Funds of India - http://www.amfiindia.com/). Which MF can you choose, how will it perform, how will the fund manager act with your money, NOTHING is certain. In Holland, where I did my Masters Studies, there are more mutual funds available, than the no. of stocks listed on the Amsterdam stock exchange. If it was so easy to make money in the market, everyone would make money just by investing in these funds or by going for diversification at individual levels.

The fact is that there is no individual – educated or experienced, uneducated or na├»ve, businessmen or layman, trader or fund manager – absolutely no one can guarantee anything in the markets. Hundreds of factors play role in the valuation of the stocks. Predicting them is a dangerous and highly inaccurate error-prone task. If you believe that you are doing the right selection of stocks at your level, the fund managers atleast have some advantage over your inexperience and ignorance. They have much more money than you to play around with. If you “Invest for LONG TERM”, then every single fund also advises individuals to invest for long term, & the mutual funds carry on for long term. And still the fund managers fail, without guaranteeing anything. How can we, INDIVIDUALS, be so sure of making sure shot profits?
Once again, let me reiterate - Things work RANDOMLY. It’s a risky business; make sure you understand the risk for your hard earned money before jumping in.

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