Know. Think. Then Invest.

Aam aadmi is always busy in trying to meet his ends. Whether business or employment, people are looking for ways that lead to financial freedom. Children, house, retirement, health, lifestyle are some of the requirements which haunt a typical household everyday when they hear about a price hike. Most of the life of an individual is spent in catering to the ROTI, KAPDA & MAKAAN for his family. This is irrespective of the fact that the requirements get satisfied very soon but the wants keep on increasing with every accomplishment.

Now to fulfill the needs & satiate the desires, a person works. He gets salary or profits. He uses this money to buy necessities and luxuries. He is not satisfied. He wants more money. Not only for this time but future also. Future requires us to save money. So we have bank accounts. But value of a thing/facility now will not remain same in future. Hence we need not just our savings but a return over these. This introduces a world of financial products.

There is an important thing to understand. People look at their peers, watch advertisements, read articles and hear discussions, and take investment decisions. No two patients are same for a doctor and each patient needs a specific treatment for same illness, each investor is also unique in terms of his risk profile and return expectations. Before investing a rupee in the market, one should ask himself, do I understand what it means to invest in this particular security. People can judge promises like doubling the money, right product for you, we are the experts, etc. only when they understand what's behind them. I may not want to double my money but a descent return, just over inflation, but preserve my investment as I see my brother going to college next year.

Broadly for a common man, debt and equity products fill asset classes. Each of these classes has numerous products for people with different risk and return profiles. But do we as investors analyse which product suits me? No. And this is what brings windfall gains to one and suicidal situation for other.

Debt Products - These are saving plans where the risk is low. For a common man, risk should mean probability of loss of investment. If you put Rs. 100 in a product, how much are the chances that you will face a reduction in your investment i.e. Rs. 100. This is important. Ignorance can be no excuse here. When we go outside the world of traditional and nearly risk-free investments, like bank & post office saving facilities (FD, RD, NSC, PPF, etc.), we are entering a world of uncertainty. Understanding of this very concept makes life of people hell or heaven. Repetition of sentences is intentional here owing to their importance. Debt investments can be suitable for people who have safety of investment as their short term goal and a descent return over traditional products in the long term. Short term can be construed as six months to one year. Descent return can be something greater than 2%. So if you see a requirement of your cash in the coming next quarter, stay attached to FDs or savings account. If your requirement extends to about a year, debt mutual funds (liquid & short term) can be suitable. Pl note to Know. Think. Then Invest.

Equity Products - Equity is becoming part of portfolio of everyone these days, even for those in tier-3 cities. This is what is going wrong. People are playing with petrol without trying to know that it is highly combustible. Whose fault will it be if someone catches fire. One would say - "What a fool!". Another example can be shopping. If you buy the same gadget for Rs. 100 more than what your friend paid, you feel cheated. But the market will say, he did n't do enough research. What then can be said for our dear investor. Equity is most rewarding in the long term. This is the most common statement in investment prospectuses and textbooks and no one can deny the fact. Equities are wealth generating machines, if used appropriately. Else make life hell. People have put their life savings, daughter's dowry, mortgaged their properties and put money in equity to make a fortune. Reliance Power IPO was such one case. Equities have very varying returns and so is the most risky investment option.

Then should we not invest in equities? No. Idea is to understand. Equities are based on price of shares which depend on the market. If market is in good mood, you are rewarded. So now two important consideration points for investors arise. One for how long to invest. Second, which companies/mutual funds to invest in. "how long" can be said to be more than 2 or 3 years. This duration is not anchored. But an investor should be ready to be without his investment for such a time horizon, else if markets are unhappy, he may have to liquidate at a loss. For the part of which companies/funds to invest in, if you find it hard to understand growth, sectors, valuation, etc. please go for front-end companies like TATAs, RELIANCEs, MAHINDRAs, top banks, etc. These and such companies with credible management (we read interviews, comments of their promoters in all newspapers) and best of brands (whether cars, electronics, banks, power, etc.) which are famous India-wide. The speculation here is that such companies shall show descent growth and a low risk of loss of investment over our time horizon (discussed above). Small caps, mid caps, growth companies, next this and next that are terms useful for those who can evaluate the variables on which these phrases are based. Mutual funds are an even less riskier option. There are many websites which provide rating to mutual funds. Informed decision should be to cross check the ratings, performance of funds over relevant period and check for the consistency of returns. A one time star performer can be risky. Looking for top five performers over past 3-5 years can help us in shortlisting useful players.

Investing can make you rich. How? When? These are the questions that you have to understand. Never losing your money is what "father of modern investing" Warren Buffett preaches. Therefore, know (risk and return), think (how your risk profile affects the choice of investments, and what should be, thus, your return expectation) and invest (put your hard-earned money and reap returns).

EPS or ROE? Choose Wisely.

Warren Buffett is one of the most amazing personalities in the investment world. First thing that surprises someone is his past performance. Second his style of investment. Finally, it's his words of wisdom (shared through his interviews, articles and shareholders' letters) that make your think differently about things, market and life. Inspired by an interview of Prof. Sanjay Bakshi, a faculty at MDI and CEO of Tactica Capital Management, I started reading Buffett's Shareholder letters starting from 1977 available from Berkshire Hathaway website.

 

The first few paragraphs of the first letter made me realize the power of thinking of Mr. Buffett. The letter contains the following lesson for investors –

Most companies define "record" earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.

 

The above 3-liner has a very important instruction hidden in it. As investors, what metric should they choose to evaluate management's performance – EPS or ROE? Honestly, it took me about 4 hours and some net search to understand it. Finally I got an article, which elaborated what Mr. Buffett wanted the investor to realize. Most companies show, in their results, how much growth they have achieved. Growth in Gross Income, EBIT, PAT, EPS and asset size is very common. And yes, each of these is performance measurement parameters which depict the outcome of efforts of management in utilizing assets of the company.

EPS is a very common figure. Analysts compare the EPS of companies in the same sector and over a period of time. What Mr. Buffett says in the above paragraph is that investors should not just be mesmerized by the EPS number only. They should realize this that they have invested a particular sum which gets increased every year because companies do not distribute their entire net earnings but retain a portion for future investment or other uses of the company. To know, how much return an investor has got over his investment, is depicted by ROE. Since retained earnings increase the equity portion of the company, the management is expected to give the shareholders a return over this amount (equity). Say a company has the following financials –

Year	I	II	III	IV
Beginning Equity	100	110	122	137.6
PAT	10	12	15.6	21.84
Ending Equity	110	122	137.6	159.44
Earnings Growth		20%	30%	40%
ROE	10%	10%	12%	15%

 

At a glance on the numbers we find that the PAT has increased significantly by 20%, 30% and 40% in the four years. Looking at these numbers makes us pat the back of management for superb performance. But the ROE numbers seem to be not extra-ordinary. We can see a rise in ROE to 15% over a four year period, much below the PAT growth.

 

This is a very important realization for us as investors – even a savings account, which is not to be managed by the investor and is more or less risk free, pays a 3.5% interest on the balance (that increases by the amount of interest credited to the account every time). For investors who are risking their money, they deserve an increasing ROE on their investment, which also gets increased by the amount of increase in reserves.

 

To get a better sense of what Mr. Buffett says above, following are the PAT growth and ROE numbers for top telecom companies included in CNX500.

Bharti	2009	2008	2007	2006	2005
EPS	40.79	32.9	21.27	10.62	6.53
Growth in EPS	24%	55%	100%	63%
ROE	34%	32%	35%	27%	26%
Growth in ROE	5%	-9%	28%	5%

The above numbers, taken from ICICI DIRECT, make the concept clear. A remarkable increase in EPS is not followed by a similar result in ROE. As an investor it should be the ROE which falls negative in the year 2008.

 

There are many numbers that one can look at while making an investment. Understanding and utilizing the numbers differentiates the investor/analyst.

 

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