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 ?
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.
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)
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.
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 ?
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 ?
What are Futures ?
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 trade Futures :
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.
What are Options ?
· Call option and
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.
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).
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.
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).
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.
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
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?
Each of these has its 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!