Investing Fundamentals

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FIRST PRIORITY SHOULD BE TO ENSURE ADEQUATE

LIQUIDITY

MAKE SHORT TERM INVESTMENTS TO

MAINTAIN LIQUIDITY AND EARN SOME RETURNS

AVOID UNUSUALLY HIGH RETURN INVESTMENTS-IT

MAY BE RISKY

Return from investing in stock-Dividends

Price appreciation also called capital appreciation or capital gain

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Growth Stocks Vs Income Stocks

# Income stocks- generally older, established firms that have less chance for substantial growth and less variable earnings

Swaraj Auto, Oracle Fin., Infosys etc

The income companies believe in declaration of high dividends.

# Growth stocks- generally younger firms that have more growth opportunities and more variable earnings

ICICI, HCL, Eicher, Indiabulls etc.The growth companies give low dividends

Bonds Return from investing in bonds is in

the form of coupon payments and price appreciation

Mutual Funds Return from investing in mutual funds comes

from coupon or dividend payments generated by the portfolio of the fund

Real estate Buying a home or purchasing rental property or

land

Return from investing in real estate comes in the form of rent payments and selling the property for a higher price than paid for it

INVESTMENT RETURN AND RISK

Measuring the return on your investment

Total return = Cash payment received + price change over the period

Purchase price of the asset

Example: If you pay $1,000 to make an investment and receive $1,100 when you sell the investment in one year, you earn a return of:

R =

$1,100 - $1,000 = .10 or 10%

$1,000

DIFFERING TAX RATES ON RETURNS

Income received as interest payment is classified as ordinary income

The income from sale of investments is called capital gain

long term capital gain (LTCG)-Capital gains resulting from sale of investments

held more than one year in case of- shares and equity MFs.

held for more than three years in case of- property, land, gold, shares sold off market etc.

Short term capital gain (STCG)- if held for shorter durations as in the above cases. 7

Differing tax rates on returnsShare dividends are not taxable in India.STCG from investments in stocks (if levied STT) are

taxed at 15%LTCG from sale of stocks (if levied STT) are not

taxable.

CAPITAL ASSETSSTCG from sale of capital assets are taxed as

ordinary income.LTCG from sale of capital assets are taxed at 10%

without indexation (Sale – cost), or 20% with indexation (Sale – Indexed cost), whichever is lower.

(LTCG = sale price – indexed cost of acquisition)

Indexed Cost of Acquisition or inflated cost = Actual Purchase Price * (Cost Inflation index during the year of sale / Cost Inflation Index during the year of purchase)

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Let us try to understand this with a simple example.

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

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

Long Term Capital Gains would be calculated as :

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

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

INVESTMENT RETURN AND RISK (CONT’D)

Risk from investing Returns are uncertain

Future values of investments are dependent on demand by investors

Before you select an investment, you should assess the risk

Measuring an investment’s riskAll stocks are subject to two forms of risk –

Systematic risk is the risk that all publicly traded equities share due to market-wide movements.

Wall Street proverb “a rising tide raises all boats

Non-systematic risk is based on the earnings strength of the underlying company of your stock, and not the overall market.

Non-systematic risk is generally more manageable than systematic risk for the individual investor.

The traditional way of offsetting non-systematic risk is diversification across different sectors and asset classes

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1. Range of returns: returns of a specific investment over a given period

(range = highest return – lowest return)

2. Standard deviation: standard deviation of stocks monthly returns. It measures the degree of volatility in the stock’s return over time

A risky stock will normally have a relatively wide range of returns and a high standard deviation of returns

There are other subjective measures of risk

Measures of Risk

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3. Beta

Beta measures nondiversifiable risk i.e. Systematic risk.

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

The whole market is assigned a beta of 1.

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

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

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

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

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Beta for one year period November 2012 – October 2013

Company BetaLARSEN & TOU 1.3MAHINDRA & M 0.92TATA MOTORS 1.56HIND UNI LT 0.33I T C LTD 0.52STERLITE IN 1.66WIPRO LTD. 0.75SUN PHARMACE 0.52GAIL INDIA 0.52ICICI BANK L 1.54JINDAL STEEL 1.46BHARTI ARTL 0.87MARUTISUZUK 0.7TCS LTD. 0.88NTPC LTD 0.77BAJAJ AUTO 0.65COAL INDIA 0.64   SENSEX 1

CompanyBeta

ValuesHOUSING DEVELOPMENT FINANCE CORP.LTD. 1.3

CIPLA LTD. 0.59

BHARAT HEAVY ELECTRICALS LTD. 1.42

STATE BANK OF INDIA 1.13

DR.REDDY'S LABORATORIES LTD. 0.56

HDFC BANK LTD. 1.2

HERO MOTOCORP LTD. 0.67

INFOSYS LTD. 0.58

Sesa Sterlite Limited 1.32

OIL AND NATURAL GAS CORPORATION LTD. 1.24

RELIANCE INDUSTRIES LTD. 1.11

TATA POWER CO.LTD. 1.01

HINDALCO INDUSTRIES LTD. 1.32

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Using Beta to Estimate Returns

Capital Asset Pricing Model-

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

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

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

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

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

TRADEOFF BETWEEN RETURN AND RISK Return-risk tradeoff among stocks

Small firms tend to have more growth potential, but higher risk

IPOs may offer high returns, but also have high risk, especially for individual investors

Return-risk tradeoff among bonds Large, well-known firms have low return, low risk High risk bonds offer higher payments

LEARNING FROM THE INVESTMENT MISTAKES OF OTHERS Making decisions based on unrealistic goals

Borrowing to invest

Taking risks to recover losses from previous investments

Focus on Ethics: Falling prey to online investment fraud Avoid making decisions without facts

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