Investment School: 2008-09-21

How double indexation increases return in FMP?

Finance minister Mr P.Chidambaram in one of the award function asked the recipient of the award "What is your wish list in this year's budget" and the recipient "he din want to pay more taxes" and the recipient is none other than India richest person Mr Mukesh Ambani. In return FM commented that "India is a country where a normal person as well as the richest person does not want to pay taxes".

If Mukesh Ambani himself is more conscious about paying taxes, aam aadmi like you and me should be trying to save taxes in a judicious manner. So lets see how we can reduce taxes on Fixed Maturity Plan by double indexation.

How is the profit taxed from debt mutual funds?

Debt mutual funds have a long term capital gain tax which is taxing the interest if the investment is held for more than a year. There are two methods of taxation.

1. 10% on the interest gained without indexation.

Taxable amount = Amount Returned - Amount Invested

2. 20% on the interest gained without indexation.

In the second gain, the taxable amount is calculated by

Taxable amount = Amount Returned – (Amount Invested * Inflation Index for Redemption financial Year/ Inflation Index for Investment financial Year)

Inflation index for every year is released by the govt.

Lets understand this concept with an example.

Assuming an FMP of 15 months returning 11% and Rs 10,000 is invested. Inflation index for 2006-2007 100 and inflation index for 2007-2008 is 105 and for 2008-2009 is 111. s Tax is calculated using indexation at the rate of 20%.

Scenario 1:

Amount invested in sep 2007.

Amount redeemed in Dec 2008 = Rs 11,000

Taxable Amount = 11000 - (10000 * (inflation index for 2008-2009 / inflation index for 2007-2008))

= 11000 - (10000 * 111/105)

= 11000 - 10571 = 430

Tax @ 20% = 20% of 430 = 86

Amount redeemed = 10914.

Scenario 2:

Amount invested in Mar 2007.

Amount redeemed in Dec 2008 = Rs 11,000

Taxable Amount = 11000 - (10000 * (inflation index for 2008-2009 / inflation index for 2006-2007))

= 11000 - (10000 * 111/100)

= 11000 - 11100 = -100

Net Loss = 100 and hence no tax.

Amount redeemed = 11000

So in this case we have totally avoided tax.

Hence while planning an FMP investment, we should plan it in such a way that it spans two financial years to get the advantage of double indexation.

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What is Fundamental Analysis?

When it comes investing in stocks, there are two schools of thoughts - Fundamental Analysis and Technical Analysis. Fundamental analysis focusses on company economic factors to make an investment decision whereas technical analysis focus on stock price movements to determine the investment. Let us get started with fundamental analysis and what are the various factors affecting fundamental analysis.

     Fundamental analysis of a stock should answer the following questions related to the stock.

1. How is the company growing in terms of revenues and earnings over the past?
2. Has the company been able to maintain healthy profit consistently over the past?
3. How good is the company placed with respect to its competitors?
4. How good is the management of the company?
5. How transparent are the company's operations and decisions?

      These are only few , more questions on the similar note needs to be answered to fulfill a fundamental analysis of the company.

Factors affecting Fundamental Analysis:

             Quantitative factors - The factors which can be measured in numeric terms like net profit growth,revenue growth, equity:debt ratio, EPS, P/E Ratio etc.
              Qualitative factors - Quality of management of the company, brand value of the company etc.

          Both these factors are equally important and should be considered in conjunction while choosing a stock. For eg, Coke has a good track record of financials and also a great brand value which also contributes to its sales. Some of Warren Buffet's(Richest person on earth) investment are shining examples of fundamental analysis. He invested in coke for a simple reason that people will not ditch coke no matter how many times they drink it, coz it has a brand value associated with it. 

          Fundamental analysis will help in identifying the "intrinsic value" of the company.  For eg a company trading at Rs 100 may have a intrinsic value of 200 rs which can be identified by fundamental analysis. In the long run stock markets will reflect the fundamentals of the company.
           Lets look into the factors affecting fundamental analysis in deep in the coming posts.

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How does inflation affect your invesment?

 Before going on with the topic, i would like to take some time and say a "big thanks" to all readers/subscribers of "Investment School" on the occasion of the 50th post of my blog. I am encouraged by your astounding response to my blog and consistent tracking of my blog.  Its your active reading that makes me to write more on investment and best practises. Thanks again!

Come every friday morning, you get to see inflation numbers in bold figures in the newspapers and television channels. So how does inflation affect a common man and its investments?So lets understand inflation and its impacts.

What is inflation?

To put it in simple terms, inflation is nothing but an increase in cost of living for a person on a yearly basis.

Eg. If inflation is 8%, then theortically a good which was sold for 100 rs an year back is now costing Rs 108. So inflation is not a very tricky and difficult to understand , it is as simple as the above example.

How does inflation affects investments?

Inflation reduces the purchasing power of money. 100 rupees can purchase you more last year than what it can purchase as per the last example.

Inflation also erodes investment. Lets see this with an example.

Eg. Ram invests Rs.1,00,000 in a bank FD fetching him 11% interest rate on yearly basis. Ram is in a income tax bracket of 20%.At the end of one year, he gets back Rs.1,11,000 and he pays 20% of 11,000 as tax.

Amount Invested = 1,00,000
Maturity Amount = 1,11,000
Interest Earned = 11,000
Tax on Interest @ 20% = 2,200
Amount in Hand = 1,08,800

Interest Earned = (8,800/1,00,000) * 100
= 8.8%

If the inflation prevailing is 7%, then

Real rate of return/Inflation adjusted return = 8.8% - 7%
= 1.8%

This implies value of money at your hand has increased only by 1.8% and not by 11% or 8.8%.

As we can see in the above example, inflation erodes the return from our investments significantly.

How to reduce the impact of inflation?

We should choose a mix of investment instruments, so that the collective return out of our investment should beat inflation by a good margin of (8-10%) so that real value of our money increases in a significant manner.

Lets rework the same example above by splitting across two investment instruments - debt and equity invested for 12 months or 1 year.

Amount to be invested = 1,00,000
Amount invested in equity = 50,000
Amount invested in debt = 50,000

Interest earned in debt = 11% (0r) 5,500
Tax on interest = 20% (or) 1100
Interest - tax = 4,400
Interest earned in equity = 20% (or) 10,000

Total Interest Earned = 14,400 (or) 14.4%

Inflation = 7%
Real rate of return = 14.4% - 7% = 7.4%

So the inflation adjusted return has increased from 1.8% to 7.4% by reallocating the amount in two different modes of investment. The returns mentioned are assumptions, you need to reallocate the %age of amount in each asset class based on interest available during your investment period.

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What is P/E Ratio?

"Company XYZ is available at a cheaper PE and is a good buy". You would have come across this phrase many a times in NDTV Profit or CNBC-TV18 or in the business newspapers. Most of us make an investment on recommendations from either friends/newspaper/TV channels and overlook technical parameters. Let us understand about these parameter and let me tell you it is not rocket science to learn these.

What is P/E Ratio?

P/E Ratio = Price of one share of a company/Earnings Per Share of the company.

Usually, EPS of the last four quarters is taken into consideration and the resultant P/E is called trailing P/E.If the expected EPS for the next few quarters is taken into account, we arrive at Forward P/E.

How to use P/E Ratio?

P/E Ratio can help investor take their decision to buy a stock. P/E indicates how much Rs is needed to generate a earning of Rs 1.

Eg. If P/E of company XYZ is 20, then it indicates, an investor is willing to pay Rs 20 to generate Rs 1 as earnings for the company.

P/E value varies across sectors. Banks have a lower P/E whereas the tail sector may have a higher P/E. Investors are willing to pay more for a retail company to generate earnings than they want to pay for Banks.

How to use P/E ratio along with other parameters?

As stated in one of the previous article, any technical parameter should not be considered alone to take a buy/sell decision. They should be analysed in conjunction with other parameters.

P/E ratio should be analyzed along with the growth rate of the company. If a company has a higher P/E ratio and but the future growth of the company is not very encouraging, then one should rethink on his decision to buy the stock. P/E of a company should be compared only with its peers. For eg, Infosys P/E should not be compared with SBI's P/E.

To reiterate, P/E should not be the only guiding factor to make your buy/sell decision. One should consider all factors affecting a stock's price before taking a call.

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What is short covering?

In the previous article, we have seen about short selling and what are the risks involved. As promised in the last article, let us see how to mitigate the risk associated with short selling. We shall look at this with an example.

Trader Ram, borrows 50 stock of company XYZ at Rs 100 and promises to give back the stocks to the lender in a months time. Ram anticipates that the stock price of the company would go down to 80 rs and he is planning to buy back the share at 80 rs. Unfortunately , due to external and market conditions, the stock price of the company XYZ rallies to Rs 120 and there is only 3 more days for the month end and Ram has to buy back the shares and deliver it to the lender.

So Ram is in a loss of 20 rs/share and he has only 3 days to go and the market sentiment is very bullish and the stock price of company XYZ can appreciate further. Hence Ram decides to trim his loss at 20 rs/share and buys the share at 120 rs. Share market is not a place with only Ram as a short seller. There are numerous short sellers in the market and say 500 people had short sold the stock of company XYZ. All of them would be trimming their losses and all of them would be buying at higher stock price of 120 rs.

When 500 people places buy order for company XYZ at 120 rs, the company's stock price will eventually go further up and this increases the stock price of the company. This entire process is called "Short Covering". Short covering will lead to a rally in the overall market and these are called short covering rallies. When most of the traders had predicted that the market will touch lower levels, due to some global cues or other factors if the market rises, we tend to see the short covering rally.

The practises of short selling and short covering only suits traders and investors should try to stay away from risky practises.

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What is short selling?

Most of us are taken back with the stock market crash of late eroding our investment value, but you would be surprised to know that you can make profits even in a crashing market. Want to know how is that possible at all? To know how to make money in a bear market, we need to understand the concept of short selling.

What is short selling?

Short selling is selling of a stock which is not owned by a seller. When a trader feels that the stock price of a particular company will fall in the near future, he indulges in short selling. Let us see how it works with a simple example.

Eg. Suppose say, trader Ram feels that stock price of company XYZ currently trading at 1000 rs will go down significantly in the near future due to market correction or any other reason. Ram borrows certain number of stocks,say 20, of company XYZ from his broker for 1000 rs/share.The commitment is that he will have to return back 20 shares to the broker on a specified date in the future say in one month's time.

After purchasing the stock at 1000 rs, Ram immediately sells the stock at 1000 rs and gets 20,000. As expected the stock price of the company XYZ falls by say 100 rs and is at 900 rs at the end of one month. So Ram buys back 20 shares of XYZ at 900/share thereby spending 18,000 and gives back the shares to the broker.

Hence Ram has gained 2,000 from short selling of company XYZ.

Risk Involved

Making money is not that easy. So once you buy the stocks assuming that it's price will go down, what if the price begins to rise due to the overall market sentiment and in these days, where the market volatility is very high the markets can go up and down in a days time and hence there is significant risk involved in short selling.

So should we not indulge in short selling at all? If involved how to trim our losses? The answer is short covering. Let us digg on that in the upcoming posts.

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