Month: January 2018

Chapter 3- Debentures, Securities, IPO, Futures & Options & Mutual Funds

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Debentures & Bonds

Debentures are portions of debt to the company against which the company returns a fixed rate of Interest. A debenture would typically return fixed payments at scheduled intervals of time. Debentures are different from other loans in that they are backed only by the borrower’s integrity – which means one can lose the amount if the company shuts its doors. That explains why debentures would typically have higher rates of interest in return as compared to Banks. A Debenture is another instrument of raising funds used by companies. A debenture is defined as an unsecured bond that is backed by the issuer’s legally binding promise to pay interest and principle when due. A debenture works like a loan with no collateral guarantee. So when we buy debentures, we become creditors for the company. Buying debentures amounts to lending money to the company, against which the company guarantees payment in the form of interest at a predefined fixed rate. 

Debentures are also referred to as Bonds. In the Share Market, another term used frequently by Analysts and Media persons alike is “Securities”. Securities are just a Broad term covering all financial instruments, usually stocks, bonds, money market instruments, or mutual fund shares that are issued by corporations; municipalities; state, local, or national governments; or investment companies to raise or borrow money or give the public an opportunity to participate in the growth of a company.

Hence Debentures are Creditorship securities, where as Equity Shares are Ownership Securities. Therefore a debenture holder does not have any voting rights and gets a fixed rate of return per year where as the Shareholder gets varying returns in the form of dividends. Since Debentures are riskier than Bank Loans, it is easy to understand why the rates of return are also higher than returns from a Bank.

Another term you will often hear during Analysis of a Company is the Debt:Equity ratio. This just states the ratio of the amount of initial capital of the company has been raised through Equity (ownership of other people) and the amount that has been raised through Debt (through Debentures or Financial Loans).

What are Mutual Funds ?

A Mutual Fund is a financial company that brings together a group of people and invests their money in stocks and bonds. Each investor owns shares in this Mutual Fund, which represents a portion of the holdings of the fund. The Mutual Fund earns through Dividends on the Shares it invests in, through Interest in Debentures bought and through Capital Gains (profit earned through appreciation of the Shares that were invested in).

When we invest in a mutual fund, we are actually buying shares (or portions) of the Mutual Fund and therefore become a shareholder of the fund. By pooling money together in a mutual fund, investors can purchase stocks or bonds with much lower trading costs than if they tried to do it on their own. However, they do include the cost of running the company and paying the Fund Managers and the experts who decide where to invest and how much to invest.
Mutual Funds are generally good for people who neither have the time nor the inclination to watch and follow the market and want to leave it to people who are more experienced. However, if you want to learn and follow what is going on in the Share Market, you might want to stay away from Mutual Funds for some time.

There are many different types of Mutual Funds and the names would give you a good indicator to the sort of companies these funds would be investing in – e.g. Equity Funds, Index Funds, Sector Funds, Tax Savings Funds, Balanced Funds etc.

NAV (Net Asset Value)

NAV or Net Asset Value is the ratio that is used to measure the Performance of a Mutual Fund. The NAV of a Mutual Fund is the Ratio of its total Assets (market value of Shares plus Cash reserves) minus its Operation Expenses to the No of Units issued by the fund.

If we were to draw a parallel, NAV of a Mutual Fund would be like the Market Value of the Share of a Company. NAV fluctuates on Market Value fluctuation of the Market Value of the Shares that it has invested in. It is calculated at the end of each Trading day and reported next day as the latest NAV of that Mutual Fund.

IPO (Initial Public Offering)

IPO is an abbreviation for “Initial Public Offering” which signifies a company’s first sale of shares to the public. When a company declares an IPO, it is on its way to becoming a “Public” company, hence the term “going public.” With an IPO, a company raises money from the public for the first time through sale of Shares and Debentures. These Shares and Debentures are called New Issues. At an IPO, a company can sell the shares at Par (at Nominal or Face Value) or at a Premium (above Nominal or Face value) depending on how long the company has been in existence, its profitability, current Assets and many other factors.
If we apply for an IPO and are allocated some New Issues, we are said to be purchasing from the Primary Market. However, if we purchase shares or debentures already listed and trading at the Stock Exchange through Brokers, we are said to be purchasing from the Secondary Market.

When a company decides to raise capital through an IPO, there is generally a widespread publicity about the IPO through Print and Media Ads. These advertisements highlight the important facts about the issue and also mention the list of brokers and bankers through which you can apply for the IPO. The prospectus and application form to the IPO are usually available Free of cost from these Brokers. Applying to an IPO does not guarantee allotment of shares. Very often the issue gets oversubscribed several times and then there are various ways in which the companies figure out the list of final allotees. When an IPO is issued through a Book Building Process reservations are made for FIs(Financial Institutions) , HNIs (High Networth Individuals) and Retail Investors( who apply for less than Rs. 50,000 worth of shares). Companies cannot allot shares arbitrarily. They need to do so in consultation with the Stock Exchange Authorities. The principles of allotment usually favour the larger applicants.

What are Derivatives ?

Derivatives, as the name suggests. Are financial instruments whose value is dependent on another underlying asset. The underlying security in the case of equity derivatives is an equity share. Or the widely followed nifty and sensex indices. A share of equity can only provide an unhedged position whether long or short, and the entire risk of the transaction lies with the trader on investor.

There are two types of derivatives. One is the futures product and the other is the options product and trading strategies can be created using them individually or in combination. Derivatives add a lot of flexibility to a trader’s tools. They can be used for two purposes, namely speculation and hedging.

What is Speculation ?

Contrary to what many people believe, speculation is not gambling speculation is the skill of analysing data and taking positions an the various market situations to profit from favourable price movements. In the stock market arena. This activity is also called trading. Throughout the remainder of this book, speculation in the stock market will be referred to as trading. Which includes going both long and short an the market. Also contrary to popular opinion, trading is neither about predicting the direction of the stock market nor is it about predicting prices. The most important aspect of trading is money
Management there is a complete chapter later in this book which deals with the issue of money management ( Chapter 12 )

Briefly, money management involves risking a particular amount of money to make several times the amount risked. There are various situation, called setups on the technical charts, which increase the probability of successful trades. But and I want to state this loud and clear. Since no one can predict the stock market. The key to making money in trading an a sustained basis is to make big profits when you are right and limit your losses when you go wrong. Also important is the size of your trading positions in proportion to the overall size of your trading capital ; correct position sizes enable you to stay in the game for the longest possible time and hence increase the chances of making money.

Anyone who has bought this book in the hope of making easy money can stop reading it right now. Trading is a skill that is learnt over a period of time. No one is born with this talent. No one has a holy grail which can predict stock price consistently over any length of time. This is the most important lesson of this book. Once you stop chasing the otherwise wasted in trying to find the perfect system. I often see people predicting prices in the media which can lead novice traders to believe that this is a skill which can be acquired. I will only say that if these experts had any such magical knowledge. They would not be sharing it on television with the rest of us for free but, instead, be sitting on beach in California.

trading in fact, is a skill that can be learnt and once learnt you can make huge amounts of money. To do so traders should get used to the notion of losses at the very outset. Trading is both about profits and losses. The key is to keep losses small and profit big.

What is Hedging ?

The idea of hedging is more important in the commodities and currency market. In the equity market, hedging can be an expensive exercise. Often people think they will be fully protected if they take a position which profits if the market starts moving in the reverse direction. True they will protect themselves but not totally because hedging comes at a cost, for while hedging can reduce losses but it also lowers your profits. In my experience, it is not worthwhile for trader to hedge their positions. Instead, when a trade starts moving contrary to we hear recommendations about buying stock futures and hedging it by buying a put. This strategy sounds great but the put comes at a cost which is deductible from the profits that you earn on futures, assuming that the profit an your futures position is higher than the cost of the put.

What are Futures ?

A equity futures product is a derivative of either an underlying stock, or a stock index. In other words, the value of futures depends on that of its underlying stock or index, as the case may be.

During the rest of this book we will distinguish the stock market consisting of all the listed stocks by calling it the cash market. The term derivatives market, or futures market, will be used to refer to the futures and options market.

Here it is important to understand how a futures contract is different from the underlying stock:
· when you buy a stock you pay the full value of the transaction (i.e. the number of shares multiplied by market price of ach share).
· There is no time component, you own the stock for all times to come.
· You make a loss or profit only when you sell the shares you own.
· You may or may not have a long – term view on the stock.
· You can go long an a stock only if you own it ( because of rolling settlement). You cannot short sell unless you borrow the stock, something which is neither cheap nor convenient.
· There is no way of taking a position an the index through the cash market.
· The cash market has a market lot of one, i.e. you can buy any stock in the multiples of one unit.

When you trade Futures : 

· Long is the equivalent of initiating a futures position by buying a futures contract and then squaring up by selling it.
· Short is the equivalent of initiating the position by first selling a futures contract and then up by buying it back.
· You pay only the margin which is a fractional portion of the total transaction value, generally about 15 % in the case of index futures, and up to 50 % in the case of individual stock futures.
· All futures contracts are dated. For example, Indian futures and options settlements currently take place on the last Thursday of every month. So the current month’s futures expire on the month’s last Thursday. If a trader has to carry his position to the next month, he has to shift his position to the next month’s futures.
· Futures are generally traded using technical analysis because the product facilitates speculation ; futures are not an investment product.
· You can go long or short on the futures depending on your short-term view of the market, or a particular stock.
· The futures market helps you take a variety of views on the market and a particular stock.
· A futures contract is the smallest unit which you can trade in the futures market. A contract consists of different numbers of shares for each underlying stock. The futures market lots are decided an the basis that the minimum market lot should be worth at least Rs. 2 lakh. For example one contract of reliance futures is worth 600 shares. When you trade reliance futures, you can do so only in lots of 600 shares of reliance, which is one futures contract

Theoretically,

Futures Price = Cash Price + ( Monthly ) Cost Of Carry

In theory, the cost of carry should always be positive because of futures trade is really a carry forward product similar to the erstwhile badla. But just as badla rates sometimes became negative when the market sentiment was bearish, the cost of carry can also similarly be negative when the sentiment is poor.
Presently in India the current month’s stock or index futures are the only futures products which can really be traded. Futures for the succeeding months are usually not liquid enough for trading.
For example, during January, only the January futures would be liquid enough to be traded during most of the month. The February and March futures are unlikely to be liquid for active trading for most of January. Only in the last week of January might the February futures become liquid. This is because the futures and options settlement takes place on the last Thursday of January.

What are Options ?

Options are the second type of derivative instrument. An option is available in its most basic forms in two versions, namely :

· Call option and
· Put Option.

A Call option is the right to buy a certain asset at an agreed price, and before a certain date, by paying a premium. Put option is the right to sell a certain asset at an agreed price, on or before a certain date, by paying a premium.

A lot of Indian investors will relate to options as being akin to the advance or bayana given or received at the time of sale or purchase if a property. A better understanding of options is gained by seeing how these differ from futures.

· An option is a non – linear product where the loss is limited and the profit is unlimited. A future is a linear product where profits and losses are both unlimited.
· An option has two components built into its premium. A time component and an intrinsic value component. The value of a future is the cash price added to the cost of carry per month.
· One an option is bought, the only loss can be the premium. In the case of futures, mark to market losses need to be paid at the end of each trading session.
· Options depend more on the availability of a buyer and a seller and are not necessarily liquid at every price point. Most futures contracts are liquid enough to ensure excellent price discovery.

Categories: Debentures & Bonds

Chapter 2- Company, Shares, Dividend & Types of Shares

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Since the book assumes no prior knowledge in investment in Shares, let us briefly touch upon what Shares are, and the type of Shares. If you are aware of all the terms already you might want to skip this chapter and the next and join us again on Chapter 4. A quick brush through the Chapters 2 & 3, is advised, though. It might just trigger off a new thought and might cover some basic in greater detail than you might have picked up till now.

What is a Company?

The word company was formed from the Latin words ‘Com’ (together) and ‘Pains’ (bread). Originally the word company referred to a group of people having their meal together. Now it is used to describe a group of people who have contributed money or other infrastructure (capital) with the aim of getting labour to work on it to generate profit. Such a group needs to get itself incorporated as a legal entity in the form of a “Company”.

A company could be a Private Company (with privately held shares) or it could be a Public Company (with publicly traded shares). We will limit the discussion in this book to Public Companies since this book is all about investing in the publicly traded Share Market.

What are Shares/Stocks?

A company ownership is divided into small and equal portions, each of which is called a Share (also referred to as a Stock). Each company will have different number of shares at different prices (based on a number of factors) and these Shares or Stocks are what we (as Individual Share Market investors) purchase and sell to make our profit. We can become a shareholder in a company by purchasing shares of that company and we can transfer our ownership rights by selling our shares to others. Since the company is an independent legal entity, it is not affected by any changes in its owners.

Face Value and Market Value

The Face Value of a share (also called the Nominal Value or Par Value) is the term used to describe the value of the share when the company was formed. These shares are taken against the initial capital that goes into the company to make it a profitable business. The price at which the Share is trading currently is called the Market Value of the Share. Another term used to describe Market Value is CMP (Current Market Price).

Dividend

When companies pay part of their profits to the Shareholders, this amount paid out is called Dividend. This amount is decided by the Company’s Board based on performance and future plans of the company and the amount paid is proportional to the no of shares one owns. These can be paid on a Quarterly, Half Yearly or Annual Basis. Also, there is no compulsion to pay Dividends even if the Company is making Profits if the Board decides that using the money for some other purpose would be more beneficial in the long run. This amount can be paid in the form of Money, Shares and in some rare cases in the form of Company Products or even Property.

Dividend is calculated on the Face Value or Nominal Value. Which means if the Company declares 30% dividend, and the Face value of the shares is Rs. 10, then the company will be paying all Shareholders Rs. 3/- per share.

Equity Shares and Preference Shares

The shares that we described above can also be referred to as Equity Shares (hence the term Equity Market). It just specifies that the shares don’t carry a fixed rate of dividend. The company has the freedom to decide on the rate of dividend from time to time to provide returns to it shareholders. For the rest of the book, a mention of shares would be used to refer to Equity Shares.

Preference Shares of Preferential Shares give a fixed rate of dividend. In case the company runs in loss for a year and is not able to pay dividends even to the Preference Shareholders, then the unpaid dividends CAN be carried over till the company is able to clear all arrears on Dividend payment. Such preference shares would be called Cumulative Preference Shares. A company is not allowed (in most countries) to pay any dividends to its Equity Shareholders till all pending dividend has been paid to the Preference Shareholders.

Rights Shares

If a company wants to raise additional money to fund its expansion or diversification plan, or if it generally needs more working capital, it can do so by selling additional Equity Shares in the market. Sometimes these shares are sold on a “Rights Basis” to existing shareholders, which means the shareholders have the first right to buy these shares by virtue of their existing shareholding. Such shares are called “Rights Shares” and could be sold at par (at the Nominal Value) or at a Premium (above the Nominal Value).

Bonus Shares

Companies, when they get profitable start building up reserve cash. This cash is sometimes used to expand or diversify business. However, part of it may be used to reward existing shareholders. This can in the form of dividend or in the form of Bonus Shares. When companies find that their Equity Capital is too small relative to their growth, they capitalise a part of their reserve cash by issuing out Bonus Shares. Bonus Shares are issued out FREE to the existing shareholders in the ratio of their shareholding. In the company’s Books of Accounts this reserve cash makes it way from Reserves to Equity Capital.

Bonus shares increase the number of shares each shareholder holds, but does not dilute any shareholder’s proportionate ownership of the company. A Bonus Shares issue would typically be followed by a drop in the Share Prices, but usually not in the same proportion in which the Bonus Shares are issued. Hence a Bonus Shares issue would usually always affect all Shareholders positively.

Split

A Stock Split, as it is usually called, results from a decision by the company to distribute additional shares to the existing shareholders while reducing the Nominal Value or Face Value of the Shares in the same proportion, so as not to change the Equity Capital of the company. The Market Price of the share immediately adjusts to reflect the split, since buyers and sellers of the Share are all aware of the Stock Split. 

Companies usually declare a Split if the Price of the share rises significantly and is perceived to be too expensive for small investors to afford.

Buyback of Shares

In certain situations, a company might decide to buy back its own Shares with its own Capital. The Company’s Act debars the company from re-issuing these shares, and hence after a Buyback of Shares, the shares bought back cease to exist. This effectively reduces the Equity Capital of the company and the no of shares available in the market for trading. However, since the no of shares are reduced while the company’s earnings and profit remain the same, it leads to an increase in the CMP (Current Market Price) of the remaining shares.

Let us now move on to some other instruments of investment – Debentures, Securities and also take a look at what Mutual Funds are, how they operate, IPOs and more

Categories: Types of Shares

Chapter 1- Investment in the Stock Market

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Investment could be defined as laying out money or capital in an enterprise or medium with the expectation of profit. Another easy way of putting it could be: The use of money for the purpose of making more money, to gain income, increase capital, or both. What is important to remember is that Investments are not like savings in the Bank Account, where your money grows at a certain fixed rate (called Interest Rate) every year. An Investment entails risk of losing the amount invested – on the flipside – if successful it would give you returns that would far exceed the returns in the form of a Bank (or other) savings.

Why invest? The logic behind investment!

Slowly, all over the world, people are realizing that the only sure way to wealth over time is to make sure that not only does one work hard, but also makes his/her money work hard.

Which means while all of us in employment/business are hard at work, we also need to make sure sure that our money is also hard at work in multiplying itself. To set this in motion, we need to understand and evaluate investment options. This book is about helping you evaluate one of the best options of investment – the Stock Market!

The value of your money is judged by its buying power – which means the value is judged by the quantity of goods or services you can buy with it. If you keep your money in the form of cash, you would lose on the value of this money because of inflation (increase in the general price level of goods and services). If you keep your money as Savings in the bank, the interest you would earn would barely be a few percentage points above the rate of inflation. Hence to really make your money make more money for you (also called making your money work for you), you need to think of investing your money so that it grows way faster than inflation. That is the only way to grow wealthy over time.

As against trying to run your own business, investment is about letting your money aid the business to grow and hence derive profit from the investment. So as an investor, one does not need to do all the hard work required to run a business, but one does need to figure out which are businesses that have higher probability of doing well, and hence invest accordingly.

What are the normal investment opportunities for individuals?

The only real mode of investment over the last few years in India has been Real Estate – while most people buy their houses, some venture in buying in land and commercial Real Estate. 

Each of these has it’s own set of issues. While it is not non profitable to invest in land, usually it takes 15-20 years to appreciate significantly. Also Real Estate tends to be relatively non-liquid (which means it cannot be sold of immediately at a good rate if you need the money suddenly).

Investment in the Stock Market gives you an opportunity to gain significantly in a time frame of 4-5 years, which is what most of us are looking for. The gains can come faster for those with higher risk appetites. However, the best part about the Stock Market is that it is very liquid, and any additional money can be pumped in for a short period to derive benefit for you. Conversely if an investor in the Stock Market requires money suddenly, he can retrieve it from the market at short notice (almost immediately).

Over the past few decades, the Indian Stock Market has created a lot of wealth for a lot of investors. No wonder that the number of retail investors has increased from approx 1.5 million 20 years ago to more than 55 million today!