Employee Stock Option Plan (ESOP)

These days in campus interviews, majority of the firms which come for placements are startups. Most of the students I have spoken say we would like to join a startup as the learning opportunity is greater and the chances of making a windfall is even higher. Which is true, if the startup you have chosen to join makes it big. There are many such examples available in the market. The biggest dream a startup sell’s is ESOP’s and that is the reason the joining CTC looks big, compared to other companies. Remember that these stock options would make you a rich person only on paper, as converting them to cash would take a lot of time and conditions. First you have to remain with the organization till the vesting period, secondly, unless the entity is listed, you do not have any exit option and have to rely on what the organization says is the worth of the option. Thirdly the ESOP conditions are not easy.

I know of a young smart lady, who joined a startup for internship, there was a big bonus they had promised, but as the days came closer, she realized that she was not even halfway close to receiving the bonus. The chances of a startup closing are much higher, therefore the value of your ESOP will be worth zero unless the company really makes it big. In case it’s time to buy the shares based on your ESOP, be careful if the company has not been listed, as if it does not list, you would end up holding dud papers. ESOP’s are given by these organizations for 2 reasons, one they cannot afford to give high salaries, because they are short of cash and secondly it works as an employee retention tool. Now the tax aspect.

Tax is to be paid on the date when the ESOP is converted to Shares, i.e. you decide to put in money, this really hits you hard, as you need to put in cash and you are also taxed for the difference between vesting price and market value (book Value). Again when you actually sell the shares, it is taxable as capital gains. You would be lucky if you the shares are listed on the exchange, as if they are listed and you sold within a year of the shares being vested, it is short term capital gains taxable at 15% and if after a year, then tax free. The situation is different, if it is not sold on the exchange. The short term capital gains is taxable as per your tax slab and long term would be taxable.

Success formula for equity investing

Most of us want to invest in equity to make fast money. The reason is simple, all data shows that equity has given very good returns over a period of time. But then all good returns have their share of risk. It’s looks too easy, whom do you trust on the advice to invest. One of the best things to do is invest in a portfolio of equity shares and review them on a regular basis. Get rid of the ones not doing well, this is the most difficult part for most investors, they tend to hold on to them. You do not review your equity shares daily, it will be futile. If you had the time, then you and the rest of the world would have been doing only this. If you look at the list of wealthy people, you would have noticed that their wealth is in the form of equity shares. They invest their money in shares of a company, which they believe will grow, the company might be their own or of someone else.

So if they can get rich by holding shares, why not you and me. The challenge is picking the right shares. These wealthy people, believe in making money by participating in the growth story of the company, you and me can also do the same. But then we are lazy and want tips. What tips do you want? Look around, what do you and your neighbor’s use daily? Buy shares of those companies. If you trust those products to use daily, then the company would be growing for sure, so you should participate in the growth. There are many persons who give tips or follow tips given by many, but only a few make money. This is because only those who stuck with the shares made money. Daily trading does not make money in the long run, unless that is your full time job.

So what should one do? The easiest way would be to go for a well-diversified mutual fund scheme, where the fund manager does the job of stock selection. Best would be a index fund, here the fund manager does not need to do much, the index is managed by the stock exchange, all he has to do is ensure that his scheme is in tune with the index.

Learning from the Chinese Bamboo Tree

Not sure if you have heard of this particular species of bamboo tree in China, which takes around 5 years for the shoots to show up, but in the next 3 months it grows to a height of around 80 feet. So what the farmer does is for 5 years he just keeps watering and waiting and then in the next 3 months he just reaps the benefits. This is very similar to the stock market. Sometimes the market just keeps fluctuating for years with no major movements and then all of a sudden, the markets just keep going up and that is the time to reap the benefits. This happened last year, when the markets just went up, those who waited, just reaped the benefits. Going by this does it mean that this is not the right time to invest in the stock market. In fact, if you do systematic investments any time is the best time.

Many persons just quit watering just because they do not see the shoots, but then you have to be patient and fruits you will bear. Many of them selected the right stocks, but only walked out, just because they were tired of waiting. Investing in stocks involves waiting time, nothing happens overnight, but then nobody is ready to wait. Even though you have heard of so many success stories, you are not ready to wait. It’s not that you need the money immediately, but it’s the impatience. If I tell you invest Rs. 100/- and I’ll give you Rs. 200/- after two years, you will not accept as the waiting period is long. But if I tell you after one year you will get Rs.130/- but if you keep the money for 2 years you will get Rs.200/- you might accept. The only reason is for the additional waiting period of 1 year you could double your money. If you actually look at it, your waiting period in both the cases is 2 years, but our mind tricks us. We look for immediate results. Our mind thinks it’s just one year. If in the same way we work with a plan that you will get double only after 5 years, you just keep waiting and you will bear the fruits, but if you invest with that horizon and expect returns faster, you will not reach your target.

There are many persons who put their money in stock and wait, after the first year, the returns are small, lesser than the fixed deposit rate. They start complaining. Next year the returns are almost equal to the fixed deposit rate and they start wondering if they had taken the right decision. In the third year the markets fall and their stock are in red. Now they are on the verge of removing their money. They wait have waiting for 3 years. In the fourth year, the market moves up marginally and your investments are now at cost. This time they are frustrated and think luck is not on their side. They decide to go one more year and again the markets move up just marginally. Now the person decides to quit and market gives a small leap. This is when the shoots start showing and in a few month’s time the markets start soaring and gives you a return much better than any other investment option. You could take the parallel of the Indian stock market from 2007/8 to 2013/4 almost same number of years and those who waited made the money.

There would have been many who quit on the way. But those who waited made the money. So just like the Chinese bamboo tree, in equity investments one should wait till the money grows.

Should one trade frequently?

One of my friends called me asking for a tip, so that he could make some money in the stock market in the short run. The next question I asked him is, how much does he plan to invest and he proudly said Rs.20,000/- to 30,000/- to really make big money, you actually need to invest big and your bets should always go right. There are many more costs involved, which most of us do not consider when we talk of trading frequently in the stock market. Let us look at some of them. For every purchase and sale of a stock you have to pay brokerage costs. Why do you think brokers happily keep giving you tips? The tips are so that you trade and with every trade they make money. Remember that whatever profit you make from that a certain portion has to be paid as brokerage costs, both at the time of purchase and sale. So this brings down your profit. In addition to this brokerage fee, you also have to pay a transaction fee to stock exchange and depository charges, add to this the service tax. Now look at your profit. It would be quite miniscule.

The next thing to consider is taxation. Frequent trading means capital gains. Short term capital gains is taxed at 15%. So from whatever you made after paying the broker, stock exchange and government, the Income tax department would be standing at your doors for their share of 15%. Short term capital gains has to be paid for any stock sold before one year from the date of purchase. But if you had held it for at least a year, there is no capital gains tax. From the tax angle, frequent traders are sometimes treated as doing business of buying and selling of shares, in such a case, if you are in a higher tax bracket, you might not get the benefit of capital gains tax.

You might make some money in the short run by doing frequent trading, but with so much volatility, it is better to be careful. In the past few days you would have seen the sharp volatility in the prices of stocks. So go stop looking for short term gains and make money by investing in good stocks for the long haul.

Easy ways to make money

We regularly hear from people how they brought a stock and held on to it and today the value is so high. Well that is true for many stocks. If that was so easy, I think all of us would have been millionaires by now. Yes, in equities, holding for a long period helps generate high returns. But then not all stock will continue to give good returns for years together. Way back there was a stock called Century Mills or till recently there was Satyam, both of these were giving good returns, now where are they? Therefore if someone says buy a stock which is on the Sensex and hold on to it for life and it will give you good returns does not make sense. As both these stocks were part of the Sensex, today they are not. So is the strategy that as soon as it is removed from the Sensex sell it good? Well by the time it is removed from the sensex, that particular stock would have already lost steam.

So what should one do? One of the things would be to review the stocks you have in your portfolio on a regular basis. Daily is also regular, but at least once a year would be good enough. While reviewing if you notice that a particular stock is losing steam, get rid of it and look for some other stock which would be a good bet to replace in your portfolio. I keep telling people that the sensex has given an average ten year return of 16%, if a person had kept investing systematically. But then as I told you earlier, the sensex stock have always kept changing. So you too should keep changing the stocks in your portfolio, you would like to have such return. The easiest way to do it is invest in a mutual fund, where the fund manager would do the managing for a small fee.

Since making money in the stock market over long period of time is easy, but it needs some discipline in investing, for a fund manager, he is governed by rules, so he will follow the rules, set for the fund. This helps in disciplined investing. You keep hearing that many people made money by investing in midcap or small cap stocks, but for lay investors, it will be too much of research, stick to sensex or nifty stock and stick to them, this way the chances of losses will also be limited. Remember money is there to be made by investing and letting it appreciate, but regular review is a must. Write down your rules of investing and follow them. You might make some bad decisions, but if the rules are followed, the percentage of good decisions will always be more than the bad decisions. Isn’t this the best way to make money? Make the rules and follow them and watch your money grow.  

Don’t churn your portfolio

The only way to make money in the stock market to regularly buy and sell, this is our belief, but in reality it is not. With a government having a majority in the lok sabha there is a sense of stability with regards to governance, yes, we still need to see the results, but the stock market is on the rise. The currency is also getting stronger, thanks to the tough stand taken by the RBI with regards to inflation. If things go as they are going now, you should see the stock market just going up in the coming 2 to 3 years. One of the best things you can do now is buy the right stock and stick with it and watch it grow. Do not sit and watch the price on a daily basis. Do you do the same when you invest in real estate? No, because you are looking for long term appreciation.

Stock market is not a gambling den, if you are looking for long term gains, buy and then let the stock grow. Don’t go by just the P/E ratio, see if the company would be able to keep giving you a continuous earnings growth. How do you decide that? Look at what are the items or brands you use on a daily basis and then find out the companies which produce them. These are companies whose products, services or brands you trust and if you trust them then why not participate in the company’s growth. In this manner just purchase around 10 to 15 stocks from 3 to 4 sectors. Do not over diversify.

You can look at the price of the same stocks 3 years earlier and you would have noticed that if you had purchased them then, they would have given you better returns than the fixed returns where you have been getting. Remember the markets will keep going up and down, this would be because of cyclical trends and some news. People might tell you the next boom sector is x or y, just ignore that and go by what you would use. So start making a list of items you use, the name of the companies and then the sectors and you are on your way to make money.

Strategies to invest in the stock market

We have heard or seen very often, when the market is up, people start investing and when it is down people start selling. This trend is actually with novice investors who are very punctual about reading the newspaper and see the sensex going up and feel the need to enter or when the market falls they feel it is the right time to exit. Frankly this is the worst strategy. That is why most of us do not make it big in the stock market, we sell the winning stocks early and losing stock late. I have even seen some persons holding on to losing stocks hoping for a resurrection. Also most of us do our investment based on tips of brokers, friends and experts on television. Any free advice is risky, you should do research on stocks and then buy. Remember all stocks do not rise at the same time nor do all stock keep rising through their life.

There would be some persons who did make some extraordinary gains, but not all of us are lucky. But there are some who have taken the pains to research before entering the stock market and these persons have made money. Because these persons have either done the proper research or paid for the research, before investing. They just did not go blindly with the tips. They read when to enter the market and when to come out, they have discipline. They book profits when they need to and hold stock when needed. They just do not go by newspapers and television interviews.

 

Here are some tips to succeed in the stock market

Do a research of the sector and then the stock you want to buy.

• If your research is good, do not worry if the market is up or down, since you have purchased a stock and not the market.
• Start with small investments in a stock and buy with every fall.
• Invest for the long term
• Invest in Large-caps, since there is liquidity in these stocks. If you want to go in for mid-cap or small-cap, ensure your research is through.
• Do not just keep buying, keep a maximum of 10 to 15 stocks, which are from 3 to 5 different sectors and where the stock has strong growth prospects.
• When the fundamentals of the stock deteriorate  ….. exit
• Don’t go for all IPO’s, research before investing.

If you find all this difficult or do not have the time, switch to mutual funds, the fund managers will do all the above for you. For wealth creation, thinking and working long term is most important, do not react to short term market changes. Long term is better from tax angle as well, there is no tax on long term capital gains. Stock market is not a gambling den, if you do look at it as a gambling den, then be ready to lose heavily as well. Look at the stock market as a wealth creation opportunity. Hope these tips help you, all the best.

 

Investing in Mutual Funds is not investing in Equities

You ask any person these days to invest in Mutual funds and they will tell you the market is high, what has the market got to do with Mutual Funds. It has a lots to do, but only if you are invested in Equity mutual funds. This has happened because of the high amount of advertisement about returns in Equity Mutual Funds as well as the wrong selling by mutual fund distributors. Commissions to distributors was high in case of Equity Mutual Funds, hence they used to sell equity mutual funds. But Mutual Funds is not just Equity, there are different types of funds for different goals and also based on your investment timeframe.

If people have money lying with them and they would like to use it for the contingency purposes, then people usually keep the money in Savings bank account or fixed deposits. This money could also be kept in Liquid funds as there is no entry or exit load and the returns are better than the savings interest rate. You might say then I could keep in fixed deposits, this is one option, but when you withdraw prematurely you lose on the interest. So effectively liquid funds are better.

Investors are also scared because of the volatility of the market and would like to keep their investments safe, in such cases investors could go for Debt mutual funds. If your goal is to buy gold for your child’s wedding,   then go for gold ETF’s. This way you would slowly start accumulating gold in paper form and when you need to buy, just redeem the investment and buy the gold. This is safer than buying physical gold. Remember the designs also will keep changing so it is better to keep the money aside and buy actually when required. This also takes care of the rise or fall in the cost of gold.

In some time we would have real estate funds. So as you can see, you can invest in mutual funds depending on your goal and risk appetite. Equity in not the only option in mutual funds. In equity too, you have options, depending on your risk appetite, aggressive or conservative. In debt too you could go for hybrid funds, where you capital is kept safe and equity is used for returns. As mentioned above, mutual fund investment in not just equity investment. You can do investments in mutual funds depending on various factors. Depending on your risk appetite and investment horizon choose your fund. Don’t just go for equity mutual funds just because they give you good returns. Remember Equity mutual funds are for those whose investment horizon is minimum 7 to 10 years.

Arbitrage Funds

We have heard of different types of mutual funds and during that conversation sometimes you hear arbitrage funds or you might not have heard of it at all. What are Arbitrage Funds? To understand Arbitrage funds let us go to the definition of Arbitrage. Arbitrage means buying a product in one market and selling it in another to make a profit due to the difference on price.

So now that we know what arbitrage means how does it apply to the stock market? In the stock market trades are done in cash or future and the price in both these are different. In such a case, if the price in the future market is higher than the cash price, one can purchase the stock in cash today and deliver it in the future market at a higher price and make a profit.

That means if we invest in these funds you will never lose your capital. Then why have arbitrage funds not caught up. One reason is, the profit will take place only on a future date and if you want to exit in between there could be a chance of loss. This chance of loss is what is holding people back. But if you are ready to wait for some time, the returns are good, even better that debt funds.

Arbitrage funds are good in a rising market, as the future prices will most of the time be higher. So keep a watch on the cash and future prices of around 10 stocks and if you see the average difference reducing, it’s time to move out of the arbitrage fund.

The other advantage in arbitrage funds is taxation. Since they are mostly equity funds and for equity funds there is no long term capital gain. Even in case of short term capital gain, the tax is just 15% of the capital gain. This is better than debt funds where short term capital gain is taxable as per your tax slab.

So if you are looking at short term, arbitrage funds are better than debt funds, but for long term, equity funds are the best.

An expert in selection of Equity

Do you think you are an expert in selection of equity shares? Do you have time to track your portfolio of Equity Shares purchased. Is the number of equity shares in your portfolio only increasing and you are not able to cash out? Then why did you purchase equity shares of many companies.

If you do not have time and expertise, then you should leave the decision making of when to buy and sell equity share to experts. Yes, we would all like to buy an equity share and hope it doubles or triples in 2 or 3 years, but it does not always happen. You have to keep studying the company’s financial statements and then take a decision.

We usually buy based on tips and reviews given by experts. But if the tips have been given by experts, the time taken for the tips and reviews to reach ordinary mortals like us would be a day or two and in that time the price would have gone up. But if you still believe then wait for a dip and purchase.

The ability of a person to track his / her holding is around 20 equity shares. This is assuming he puts in enough time to read and study his/her equity shares. Even when you keep track, you should know your long term goal and your risk appetite. Since the market keeps going up and down on a daily basis. Sometimes it falls for 3 to 5 days in a row.

And if such a thing happens your portfolio will fall. But if you look closely some equity shares would have fallen more than the others or some might have actually rising. This can happen only if you have had diversification of equity shares from different sectors. So the key to a good portfolio is diversification.

A good investor selects some shares which s/he buys as a security deposit. These shares s/he will rarely trade in. These shares s/he has great hopes in and would like to keep adding as and when s/he gets an opportunity. Of course s/he might have other shares which are meant for profit making (sometimes loss making).

However good you might be never put more than 20% of your equity investments in one company. Too much exposure to one company is very risky, profits might be good, but in case of loss that too would be good. Sometimes there are special occasion’s viz. buyback, dividends, bonus etc.

In such cases one should check the risks and then take a decision. In any case do not touch your security deposit. As we had discussed earlier do you have equity shares which you had purchased in the hope of making quick profits and still holding them and you feel if was a wrong decision, sell.

Yes, you would have made a loss, but your money is not locked and you can use it to make some money or another mistake. But holding on to such shares would only erode your capital. If you had purchased an equity share for the short term and set a target, sell it on reaching the target.

Paper profits would only increase your portfolio in the short term. If you feel you want to keep it move it to your security deposit.

Select the right stock

The financial year has come to an end and most of the companies have published their accounts. Very soon they will have their annual general meeting and with that they would also announce dividends. In their published accounts in addition to the performance for the last year, they also give a guidance of how they expect the coming year to be.

The published accounts are the best data anyone could ever get of a traded stock. The published accounts in addition to talking about the organization also talk about the sector they are in. When I mentioned the management gives guidance of how they expect the year to be, they base it on some knowledge viz. orders in hand, orders in pipeline and expected projects based on sector forecast.

It s not necessary that the guidance would be right, but it gives you an idea of how the company is planning for the coming year. Most of us look at how the company fared by looking at the profit made during the year. In addition to that we should also have a look at the cashflow statement.

The cashflow statement will give you an idea if the profit is actually getting converted to cash or the receivables is only raising. The published accounts are usually audited, so it would make good sense to read the notes to the accounts. Almost every audited statement has a qualification, which should be looked at as red flags raised by the auditors.

So next time you decide to invest, buy or sell a stock, read the published accounts.

Sectors to Watch

In the earlier articles, I had mentioned that you should track sectors and select stocks from sectors which you feel would go up and sell of stocks from sectors which are not likely to do well. The experts say the economic conditions have changed and the conditions are improving.

The stock market index in creeping up, but has not yet touched the highs it had touched. So the time is right to invest and as I had said earlier, look out for sectors which will help us reach our goal of making money when the market is growing. The money inflow in the market has been increasing and as recovery picks up, more money will flow.

As more money flows in the market index will rise. But there would be other factors which are driven by nature and one of them is the monsoon. Monsoon will play a significant impact on the economy. So we have to track the monsoon. As markets rise, every stock with good fundamentals will rise.

But if the sectors in which these stocks are are on the growth path, the prices of these stocks will rise faster than the other stocks. Let us look at some of the sectors:

Information Technology (IT)

As the economic conditions improve this sector has the potential to do well. They would do well more in the domestic sector with the government taking up a lot’s of IT initiatives. One of the big ones would be the UID project. The major revenue of most of the companies is from International project.

That means billing in dollars. So we should also keep a track of the currency rate movement. If the rupee gets strong the profitability of the company with major exposure in dollar billing will see an impact on its bottom line.

Auto

As the economic condition improves, so will the salaries. This means more disposable income, leading to better lifestyle. As lifestyle improves people go in for cars, those who already have cars, want better or bigger or new cars. To take care of this, companies will be launching newer and better models to increase sales.

Though interest rates are expected to go up, it would not have a major impact on this sector as the amount required per car would be small. The stock prices in this sector are already seeing an upward trend, so fresh small purchases should be made with every dip in the market.

Pharma

This sector is most likely expected to grow, thanks to the US signing the healthcare bill, which plans to make healthcare affordable. This would increase the sales of medicines.

Infrastructure

This is one sector which has a good growth potential. Our economy is growing and with that the government is also spending more on improving the country’s infrastructure.  As you must be aware most of the infrastructure projects have a long gestation period. So only investors, with a long term view should look at this sector.

Banking

This is one sector which has been growing for some time. With infrastructure improving banks will start moving into areas which were not being serviced properly.  With interest rates on the rise, this sector will benefit the most. Whenever there is a rise in the interest rates, the loan terms are reprised immediately.

You must have experienced this with your loan. But when it comes to raising the interest rates on deposits, it happens slowly. The interest rate of fixed deposits is not revised, you have to break the fixed deposit and apply again, where again you lose, but the bank profits and if that happens the stock price will rise.

Having looked at some of the sectors, now start looking at stocks within these sectors.

Time to enter the market

When the market went down over a year back, we were scared to enter the market. After that slowly the market started moving up and it kept going up. Today it is still going up. The assessment of most of the market experts is that we have come out of recession and should serously think of entering the stock market.

Before we enter the stock market we should do some assessment of our own. First we should check what the market up’s and down have done to our current holdings. We should verify if the stocks in our current portfolios are worth what they were over a year back and also the outlook of the sectors in which we hold stocks.

If the stocks in your current portfolio are good and their sectors have a good outlook, but the stocks are being traded below the purchase price, on every fall in the market start buying in small quantities and bring down the average purchase price. But if the company’s fundamentals have changed or the outlook is not good then start getting rid of the stocks with every rise.

Also check your risk profile as of today, can you afford another fall in the portfolio value. If not think twice before investing more money in the market and get rid of the riskier stocks. Reassess you goals and decide the reason for investing in stocks and the period for which you plan to invest.

Managing equity investments is not easy, especially if we did not look at the portfolio for the past year or so. However, you should be prepared to reenter the stock market and give yourself a chance to recover from the shock. The time is ripe to juggle your portfolio and make money.

When to invest in the stock market

When it comes to stock markets the most common question is “Is this the right time to enter the market?” Those who sold when the markets were falling are worried that it might fall again. Those who purchased when the markets were falling are waiting for it to rise to a level to recover their losses. Both the set of investors are scared.

Any time is actually the right time. But instead on going by what their friends tell them, they should have purchased shares with strong fundamentals and their fear would have been less. I’m not saying fear would not be there, it would be less. Since shares with strong fundamentals will always perform.

Some people say the stock markets give an actual indication of how the economy is performing with a lag of 6 to 12 months. i.e. the markets started falling in January 2008, where as the news of recession came much later. Why is it so? Since there are analysts who track certain stock or sectors and keep advising their clients on which stocks and sectors to keep invested and which to come out of. Mind you these guys are stock or sector specific. Now as people start moving their money in and out of stocks or sectors, it gives a clear picture of the economy, which takes 6 to 12 months to collate and publish the data.

The markets have started to rise, so is this an indication that the economy is improving? No idea, it would depend on which stocks or sectors in the stock exchange index are actually going up. So you need to watch and invest. If you noticed in the last year, the persons who made money are those who purchased when the market was falling. So does that give you a strategy? Yes, buy whenever the market falls, sell when it rises. Easy to say, but if you follow this strategy you will always win. Especially in this uncertain market, for every fall in the index by 100 points, invest X amount. For every rise of 100 points exit X amount.

The stock exchange index for Bombay stock exchange is called the sensex and the index for National stock Exchange is called Nifty.

The Sensex is made up of 30 shares and Nifty is made up of 50 Shares. Almost all the shares on the Sensex are a part of the Nifty.

As mentioned earlier, invest based on stocks with strong fundamentals. One of the things to check is the amount of debt in relation to equity. A company with high debt will do well when the economy is good, but in bad times, this company will not do well.

The other is stick to index shares, these share have been made part of the index after a lot of study and research. This will lower your risk.

Dividend Investing

Over the last year or so we have seen a lot of ups and downs in the market. In this type of market buying and selling of shares by trying to time the market is like playing with fire. Another option is to look at dividend yield stocks. Dividend is a tax-free income. Investing in stocks which give regular dividends is called dividend investing.

Investing in good dividend yield shares dual advantage of a consistent cash flow in the form of dividend and potential for capital appreciation. (Dividend Investing + Capital appreciation = Great Returns)

Dividend investing focuses on identifying solid companies with a record of growing their dividends each year; and an expectation that it will continue to do so in the future. History has proved that stocks that pay constant/growing dividends have always out-performed those that don’t give any dividend or have inconsistent dividend payout history.

Dividend investing is usually considered safe in all market situations. It provides diversification and thus reduces investment risk.

Spotting a Dividend Yield Stock

Dividend yield is the dividend per share divided by price per share. In the last one year stock prices have crashed, so the dividend yield has gone up. However, one should not aim at accumulating stocks with high dividend yield because such high yields may not be sustainable in case profit falls due to economic slowdown.

There are several other things to look out for in a stock before considering it a dividend counter to invest in. Some of the determining factors include:

1. A company that has a history of paying a consistently growing dividend is better than the one that pays a consistent, but steady dividend. And the consistent but flat dividend is better than a company who has had to cut its dividend.

2. Whenever a company pays dividend, it has to pay cash. That means the company is able to generate cash from its operations to pay the shareholders. Cash flow is King. A company that generates a steady or growing operating cash flow is better able to fund a dividend than a company that cannot consistently generate cash. But take care of companies which pay dividends out of cash generated in the earlier years. Look at the cash flow statement.

3. The stronger the balance sheet the better. Stronger here meaning less debt. A company with no bank debt has a stronger balance sheet because it can borrow if necessary to support operations and the dividend if need be.
4. Keep clear of companies with high fluctuations in profits. As we all know that investing in stocks is risky
   

Derivatives and Taxation

A derivative is a financial instrument, whose value is derived from some underlying source viz. share, stock-market index, bond, currency or commodity. In other words, its value fluctuates with the value or performance of the underlying source on which it is based.
So for a small premium depending on the future value of the underlying source an agreement is made to buy or sell the underlying source at a future date.

So first the derivative offers insurance to take the uncertainty out of the future value of the underlying source. Second, derivative is risky (i.e. the potential to make large losses as well as large gains) for someone who does not have a cash position to hedge because, in return for a comparatively small payment upfront, that party accepts the consequences of what transpires in the future.

Derivatives were originally sold mainly by banks, but now they are also available on the exchange.

From the above we noted that derivative could be on any underlying source. But here we will concentrate more on derivatives traded on the stock exchange.

To make trading possible the stock exchange has set up certain standards for drawing derivative contracts.

The most common derivatives available on the exchange are Futures and Options.

Let us see what each of them are:
Futures: are contracts to buy or sell shares at a particular price on a specified future date.
Option: is a right, but not an obligation, to acquire or sell a security at a particular price.

The difference between these two types of derivative instruments is in respect of the rights and obligations of the parties involved in such contracts. In case of a futures contract, both the parties are under obligation to complete the contract on the specified date. However, in case of Options Contract, the buyer/holder has a right, but no obligation to exercise the Option, whereas the seller/writer has an obligation but no right to complete the contract.

In India the settlement of the derivative is done by squaring up the position in cash only. Also the life of the derivative cannot be for more than 3 months.

Taxation of Futures & Options

According to Circular No 3/2006, dated 27-2-2006, trading in derivatives of securities carried out on a recognised stock exchange shall not be deemed as speculative transaction.

Since Derivatives trading is relatively new one has to look at the provisions of the Income Tax Act and try to reach a conclusion.

As the circular has said it is not a speculative transaction. Trading in derivatives can be Business Income, Short Term Capital Gains or Income from other sources.

If you treat it as Income from other sources, then loss cannot be considered.

How do we decide under which head the income should be booked, we are not looking at the option of Income from other sources. Let us look at the different options and reasons available:

1) Since derivatives instruments are only for 3 months, trading in derivatives would be treated as business Income.
2) If you are devoting a major portion of your productive time in trading then it would be treated as Business Income.
3) Taking the frequency and regularity of the transactions a call can be taken if it is Business Income or capital gain.
4) If a derivative transaction is carried out to hedge your investment portfolio i.e. every 3 months square up your position and take up a fresh position. It would be treated as capital gain
5) Arbitrage transaction between cash and future markets could be treated as capital gains

Whatever the stand we take Business Income or Capital gains, what would be the cost of acquisition? As per the Income Tax Act cost of acquisition is the purchase cost as well as any other cost necessary to bring the asset into a ready and deliverable stage. Taking this into account, the premium paid on the derivative can be treated as cost of acquisition.

If it is treated as short term capital gain, the concessional tax treatment under 111A would not be allowed since this section is available only to equity shares or units of equity oriented mutual funds.

If it is treated as business transaction, what would be the turnover? Since cost is only the premium and only the difference is settled in cash. Also there could be profits and losses, should they be netted to arrive at the turnover?

The view taken currently is gross amounts of the transactions are to be considered for turnover and not just the premium amounts. Also negative amounts should also be treated as positive for the purpose of arriving at the turnover.

The reason we spoke about turnover, is as per the Income Tax Act, if business turnover is above a certain amount, then the books of account need to be audited.

Preference Shares

We have heard of different types of shares and one of the types is Preference Shares. What are preference shares? As the name suggests, it has preference over the other type of shares. Therefore equity shareholders are divided into 2 types; Ordinary shareholders and preferred shareholders.

When does this preference come into picture, it is usually in 2 situations; once when dividends are paid and secondly when the company goes into liquidation. Usually there is a percentage attached to these types of shares and this percentage is the dividend to be paid on these shares.

With the economy down and corporations in need of funds, one of the options for corporations with a win-win situation is to go for issue of preference shares. One of the problems with preference shares is, they are not liquid.

Some of the differences between preference shares and ordinary shares are
- Preference shares may be listed
- Preference shares usually has a higher divided rate
- Preference share holders are always paid dividends
- In case of liquidation Preference shareholders have preference over ordinary shareholders
- Preference shares are usually for a fixed period, like fixed deposits.

Usually there are 4 types of Preference Shares; Cumulative, non-cumulative, participating and convertible. The rest would just be a combination of these. Let us take a look at each of them.

Cumulative Preference Shares: Now cumulative means collect. So whenever a company does not pay dividends, they start accumulating and these would need to be paid before dividends are paid to ordinary share holders. In the year dividends are declared first the preferred shareholders, along with the accumulated dividend needs to be paid.

Non-cumulative Preference Shares: In this type of shares, if dividends are not declared for a particular year, they lapse.

Participating Preference Shares: In this type of preference shares in addition to normal dividend, it allows for additional dividend depending on certain circumstances viz. achieving a certain target, increase in dividend to ordinary shareholders, etc. In some cases a formula is associated for the additional dividend.

Convertible Preference Shares: These Preference shares can be converted to specified number of ordinary shares.

Hedging to make money

Hedging is an investment in order to reduce or nullify a risk taken. It is a strategy to reduce risk.

Let’s take an example I have to receive US$ 100, 3 months from today, the current exchange rate is US$ 1 = Rs. 47. So if the exchange rate remains steady I would receive Rs.4700. But I am not sure what would happen with the exchange rate, so I can sell a 3 month future contract at US$ 1 = Rs. 47. In this way I am assured of Rs. 4700, when I get my US$. In reality what happens, say after 3 months the exchange rate is US$ 1 = Rs. 45. I will receive Rs. 4500 only from the bank, but I will gain Rs. 200 from my future contract.

So is hedging normal, YES. We do it in our day to day life.

By the way, even buying a health insurance is a Hedge. We hedge our risk of an uncertain future event of falling sick and being hospitalized. What we are basically doing is making an investment to reduce or nullify our risk to bankruptcy.

How can we use this to increase our profits? Let us say I feel that there would be an announcement today that will benefit the Telecom Industry and I feel Tata Tele is better than Reliance Communication. But I am not a risk taker, so what can I do?

Let’s say the current price of Tata Tele is Rs. 16 and Reliance Communication is Rs. 216.
So what I will do is buy 63 shares of Tata Tele that will be Rs. 1008 (63 X 16) and short sell 5 shares of Reliance Communication that will be Rs. 1080 (216 X 5)

Now if there is an announcement, since Tata Tele is a better company the price of its share would definitely grow at a faster rate than the price of Reliance Communication. Let us assume the price Tata Tele became Rs.18 and Reliance Communication becomes Rs. 238. What happens? If you sell Tata Tele you will get Rs. 1197 (63 X 19) and you will have to pay for Reliance Communication Rs. 1190 (238 X 5).
Net amount you would have made is
Tata Tele – Profit Rs 189 (1197 – 1008) and Reliance Communication – Loss Rs. 110 (1190 – 1080)
Net Profit Rs. 79 (189 – 110)

But what would happen if the announcement is unfavorable. The prices of both the shares would fall, but Reliance communication would fall at a faster rate than Tata Tele. Let us assume at the end of the day the price of Tata tele became Rs. 14 and Reliance Communication become 173.
Net amount you would have made would be
Tata Tele – Loss Rs. 126 (63 X (16 – 14)) and Reliance Communication – Profit Rs. 215 (5 X (216 – 173))
Net Profit Rs. 89 (215 – 126).

So whatever the news you would make money. But the key would be to know which is a better company.

Technical Analysis

Somebody asked me what Technical Analysis is. Actually I had learnt it a long time back, and frankly do not remember any definitions. I can look at a chart and tell, OK it is about time to buy or sell. But even that I am not sure if it’s right. So actually I look at the chart and still follow my gut feel.

This article on Technical Analysis I picked from the net just gives an overview of what it means.

Technical analysis is a technique that claims the ability to forecast the future direction of stock prices through the study of past market data, primarily price and volume. Technical analysis considers only the actual price behavior of the stock, on the assumption that price reflects all relevant factors before an investor becomes aware of them through other channels.

In simple terms Technical analysts believe that the historical performance of stocks and markets are indications of future performance. A fundamental analyst would study the fundamentals of each stock and then decide whether to buy it or not. By contrast, a technical analyst would sit in his office and make a list of trades on the stock. Disregarding the intrinsic value of the stock, his or her decision would be based on the patterns or activity of people doing trade.

In reality even the analyst won’t know what would happen, he too is just speculating. For that matter all of us are. That is why we have a stock market. Everyone wants to make money and nobody wants to fail. So we rely on analysts. That is how everyone makes money.

So it’s up to you to decide if you want to believe someone or some sort of analyst. It’s your money. We are very busy people, who do not have time to study stocks. There are lots of people who do study of stocks and these guys are employed by Magazines, newspapers, TV channels, Stock brokers, Mutual funds, etc.

We read their articles, listen to the radio or listen to our friends and relatives, and reach a decision on what to buy or sell. But remember one thing, whatever anyone says follow your instincts. Ultimately it’s your money. Technical Analysis is good, it gives you a fair indication, but this indication is just based on past data.

So we should always combine this data with other analysis, data or information.

Midcap and Bluechips

The other day I was having lunch with a friend and he asked me a question, which we keep talking about all the time when it comes to stock. This was a very basic question “What are Mid Cap Stocks” It really caught me unawares. This is what I found out on surfing the net.

The term ‘mid-cap’ originates from the term medium capitalized.
Market capitalization is calculated by multiplying the current stock price with the number of shares outstanding or issued by the company. The definition of mid-cap shares can vary from market to market and from country to country. In case of India, the National Stock Exchange (NSE) defines the mid-cap stocks as stocks whose average six months’ market capitalization is between Rs 75 crore and Rs 750 crore. Thus, classification of shares into large-cap, mid-cap, small-cap is made on the basis of the relative size of the market in the country.
Mid-cap shares are considered as attractive investment avenues since their growth rate would be faster. However on the flip side, mid-cap shares are of small companies where revenue and profits could be more volatile than large companies. The availability of mid-cap shares in the secondary market is also limited. The promoter holding in these companies is high and there is very little public shareholding. Thus a volatile financial performance and the limited number of shares in the market make investing in mid -cap shares more risky. The other question that popped up was “What are Blue Chips”

The top stocks of the stock market are usually referred to as Blue Chips, the question that would pop up now is which are the top stocks. The general way would be, those stocks which are included in the index of the exchange are Blue Chips.
Generally, a blue chip has a history of solid earnings, regular and increasing dividends, and an impeccable balance sheet.

To summarize Mid-caps have the potential to be tomorrow's blue chips.
But, then again, they may not. Hence, mid-caps carry a higher risk than blue chips. Also, their earnings are much more volatile and neither are they as liquid. If you want to invest in shares but are not too savvy with the market, then blue chips are your best bet. Even if you want to invest in mid-caps, ensure that you have a few blue chips too to balance your risk.