How to Avoid Common Mistakes and Uncommon Losses

Here is the link of the video: https://www.youtube.com/watch?v=NUZ2MTJjvnU

Niteen Dharmawat is the speaker in CFA Society India’s program. He started Aurum Capital with his partner Jiten Parmar. They together have more than four decades of experience in equities and also in mentoring investors.

He starts with the discussion on timing the markets. He talks about investing in bear markets. He shares that he has never seen any instance when money is invested in bear markets and the money is lost. But people lose money when they invest in madness of bull market. He talks about compounding. The three components of compound interest are principal, return and time. Even if the principal is small but is invested over a longer tenure the amount could be very large. Investors focus on return and ignore time component. He takes a case study consisting two stocks – one having price of Rs.27 and another having price of Rs. 9785. He asked the attendees to choose between these two stocks and majority was with ‘A’ because they thought it was cheap so it is good. But the cheaper stock crashed in near future and the costly stock went up. He talks about another stock which had low of Rs.200 went up to Rs.2000 in a single year due to boom.

He talks about things which investors can do before putting in their money. Starting with creating an excel sheet, investors can write the buy price and the reason behind their investing, your expectations from this investment because people forget the reason behind their investment. Investors can also classify their portfolio using different scenarios. Further, he shares about annual reports. Often, investors are highly interested in Profit and Loss statement and ignore cash flow statement. But cash flow statement is very critical. Cash flow consist three components – investing, operating and financing. Cash flow from operations can be evaluated further because if company is selling goods and services and is receiving cash against it, it is recorded here. If a sale is on credit, then receivables are recorded and later when payments are done, cash is recognized. However, receivables are something where investors should focus because it may happen that companies are aggressively selling goods without collecting from customers. There may be some exceptions like banking /financing companies which sells cash through lending. Other things apart from CFO are checking interest expenses and comparing with net profit, checking promoter’s unpledged holding company (pledged stake should be considered as sold). It is difficult to manipulate CFO. CFO can be reported positive either by decreasing inventory or receivables or by increasing payables, but this not sustainable. Other things to be noticed are chairman or CEO’s statement or studying Management Discussion and Analysis report. In chairman’s report, first and last two paragraphs should be studied carefully. Management’s new plans to take business forward should be studied. If to the point information is not given and other numbers of industries are given then this can be a negative point because information about company is not provided. However, investors should look for result of operations, changes in financial condition etc.

Consolidated numbers should be considered instead of standalone. Other things to look in financial statements are net profit, sales, operating profit, cash flows, other income, main expenditure costs, inventory; capital work in progress etc.   

Other things to look at:

  1. Salary of directors or any revision in the salary of directors or auditors, is the revision in salary in line with growth and profit numbers?
  2. Who are the members of audit and salary committee
  3. Composition of board of directors and number of independent directors.
  4. Attendance of directors in board meeting
  5. Independence auditor’s report
  6. Shareholding Pattern

The 6 main components one should look while viewing the P&L account are:

  1. Sales Trend
  2. Operating performance
  3. Interest Component
  4. Depreciation
  5. Tax Paid
  6. Dividend Payout Ratio

The 3 main components one should look while viewing the Balance Sheet account are:

  1. Equity Dilution
  2. Share capital(Equity/Preference)
  3. Borrowings(ST/LT) versus interest component from last quarter

The 5 main components one should look while viewing the Cash Flow Statement are:

  1. CFO versus Net Income
  2. Working Capital changes
  3. Taxes paid
  4. CFI Trend
  5. CFF Trend

Mr. Niteen explains with the help of real life example how pledging of promoter affects the CFO and PAT of the company. He explains that the more the pledging done by the promoter, poorer the numbers would be.

On being asked how to decide whether to invest in a new upcoming company or not, given the absence of historical track record he says that, such stocks can be kept in your portfolio but with a very low stake.

The background of independent directors needs to be checked and it must be ensured that they have a decent educational background. Also, the information provided by the company can be cross checked to know how trust worthy the company is.

Mr. Niteen talks about various companies whose stock price almost came to zero because of insufficient cash flows, promoter pledging, Equity dilution and increasing debt.

Summary of “How the Economic Machine works by Ray Dalio”

Here is the link to the video https://youtu.be/PHe0bXAIuk0

Economy looks complex but it works in simple, mechanical way. It is made up of simple transactions which are repeated over and over again. Transactions are done by everyone. It can be done in two ways either by paying cash or on credit. By adding both of these we get total spending. It can be said that transaction is the building block of economic machine. Economy consist different markets and every market has buyers and sellers that are doing transactions. Every bank, institution, individuals etc. are transacting in the same way i.e. either by paying cash or on credit. Government is the biggest buyer and seller in an economy. Now, government can be divided among two institutions – Central government and central bank. Government is collecting taxes and spending while central bank is managing the money in an economy. Central bank manages money by interest rates and by printing new money. Credit is the most important part of an economy. It can help both lenders and borrowers to fulfil their needs. Borrowers borrow money with a promise to repay the principal with interest. When interest rates are high, borrowing is lesser in economy because it is expensive (higher interest need to be paid) and when interest rates are low, borrowings are high because it is cheap (lower interest need to be paid).

Why is credit important?

Credit is important because when people borrow money they spend and this spending is income for a third person. This third person will further spend it and it will become income for another person and this is how this cycle works. A person having good income has good credit worthiness i.e. banks are ready to lend him as he has ability to repay or put some of his assets as collateral. This is how cycles are created in economy. The more a person earns the more he raises his living standards. This is productivity growth. Productivity matters most in long run because it doesn’t fluctuate much. Debt is a driver of economy because it allows us to consume more when we borrow and we pay it back we spend less.

Let’s assume two case where in one economy doesn’t have credit and other has. In the economy with no credit, the only way through which spending can be increased is by increasing our income which require us to produce more. But in the economy where credit is available there will be cycles. This cycle is because of the nature of credit. Every time a person takes credit he spends more in that time but in future when he will have to repay it he will spend less. Credit is different from money because in money the transaction is settled immediately but in credit transaction is settled in future. Credit can be both good as well as bad depending on its usage. Example – If the credit is used to buy a T.V. it will not generate any return but if it used to buy a tractor, it will help in farming through which you can earn money. Credit leads to short term debt cycle. This is how it works – one person earns, say for example, $100,000 with no debt. He can borrow $10,000. So he can spend a total of $110,000. This $110,000 becomes another person’s income with no debt. He will be able to borrow $11,000. His spending will rise to $121,000 which will later become another person’s income and the cycle goes up. But as the cycle goes up it will need to come down. Over the time as the people will spend more, expansion will be there. As the spending is increased the prices rise too, which we refer as Inflation. In this scenario the central bank increases interest rates. This will lead to fewer borrowings and also cost of existing borrowings will rise. As the borrowing will be lesser and debt payments will be higher, this will lead to lower spending and eventually lower incomes. This again will lead to drop in price and overall economy will face recession. In this scenario, when inflation is not a problem, central bank will decrease the interest rates so that economy pick up again. Overall, when the credit is available easily there is a credit expansion and when credit is not available easily there is a recession. This cycle is managed by central bank (generally by changing interest rates). Now comes in long term debt cycle. At the end of short term debt cycle, growth and debt rises. This is because people spend more rather than paying debt. Even if people have rising debts, lenders lend freely because things are going great. Incomes are rising, spending is rising, asset prices are rising, stock market is rising and overall there is a boom. If this is done in huge volumes it is called as bubble. Rising income and asset values help borrowers remain creditworthy. As this debt burden increases slowly over time, debt repayment grows faster than income. Due to this spending is cut and income for other people decreases which makes them less creditworthy. To pay back the debt, spending is to be cut even further. Economy begins deleveraging. In deleveraging there less income, assets price falls, credit is not available, the stock market crashes. As the income drops and there is a pressure of debt repayment, people are forced to sell their assets. Due to this stock market crashes, real estate market crashes. This appears to be recession but is not. In recession, central banks changes interest rates to stimulate the borrowing. But in deleveraging the interest rates are almost near to zero or zero only. Four ways through which deleveraging (repayment of debt burdens) can be done are – cut the spending, reduce debt through defaults and restructuring, redistribution of wealth and finally central banks printing new money. But it is not that easy. As the spending is cut, income also stops for other people. Businesses cut cost which leads to removal of employees. As the employees will have no income they won’t be able to repay the loans/debt. This will result in banks unable to pay the depositors and there will be defaults all around. When credit is given both assets and liabilities arises. Lender doesn’t want to see their assets disappearing. So here comes debt restructuring. Debt restructuring means lender gets lesser money or gets money over a longer time or at a lower interest rate (from the rate which was agreed earlier). As the incomes are less and unemployment is seen, government’s source of income i.e. collecting taxes is affected. At the same time government has to spend for those who lost their jobs. Basically, government spend more than they earn. In this case government has to borrow more. But the question is from whom to borrow. Now what government does is that they raise taxes on wealthy people and by this wealth is distributed from “haves” to “have not’s”. Then central bank steps in. Central bank prints more money and buy assets and asset prices starts rising. But this will only help those who have financial assets. So government and central banks cooperate. Central bank buys government bonds which result in inflow of money for government. Then government can buy goods and services and eventually help lending money in the hands of people.  If all the factors of deleveraging are done in balanced way then deleveraging can be beautiful. If the deleveraging is done beautifully growth will be slow but debt burden will be reduced. Overall, economy will start to rise again.

Few points to remember:

  • Don’t have debt rise faster than income.
  • Don’t have income rise faster than productivity.
  • Do all that you can to raise your productivity.

Summary of video on “Physiology of Finance”

Here is the link of the article: https://www.youtube.com/watch?v=1YaWjEwHXtM&feature=youtu.be

Behavioural Finance deals with the human aspect of investing. The investor having the knowledge of behavioural finance is better off while dealing with finances. Behavioural Finance talks about the various shortcuts which investors take while investing which may not be in their best interest.

Behavioural Finance involves the study of how investors go through the cycles of greed and fear. When a particular sector is booming people become greedy and invest without seeing the risk factor. Also, when people fear because of reasons like an economic down turn they sell off all their investments.

Physiology of Finance

This involves linking finance with the biological aspects of humans. John Coates used certain methods to study the physiology of finance. Another method used was to conduct experiment on various species of animals. Levels of biological markers of the people associated with the financial markets were assessed. It involved collecting their blood samples, blood pressure levels, pulse rate at different times of a day.

There is a comparison of behavioural finance with physiology wherein the terms like fear and greed have been replaced by mania and depression in physiology.

The difference between the terms lies in their nature. Greed and fear are just a state of mind whereas mania and depression are clinical conditions.

Hormones send messages from body to brain. Like I am hungry or it is hot outside. Steroids are another class of hormones. They are powerful messengers.

Euphoria (greed equivalent) – Dopamine is chemical related to pleasure feeling in body. Over consumption of dopamine can lead to losing of interest in other things. Different activities can have different effect of dopamine like having food can increase dopamine by 50%. Let’s say by consuming a particular thing you generate a particular amount of dopamine. But this pleasure decreases over time i.e. to have same level of pleasure one has to increase the dosage of consumption. This applies to traders as well. To earn higher profits, higher risk should be taken.

Dopamine is for shorter range. Testosterone is the chemical for longer range. Blood samples were taken for traders at different times and testosterone was correlated with traders profit & loss account.

When people face stress, that time body may react in different ways like increased hear rate, increased blood pressure, sweating, passage of urine (not in all cases) etc. One has to break the cycle of Euphoria or testosterones or else it will lead to clinical situations.

Summary of article on “Other People’s Money (OPM)”

Here is the link of the article: https://www.capitalmind.in/2020/02/opm-other-peoples-money/

Generally, a company is funded by either debt or equity. However, both debt and equity come with an cost. We need to pay an interest on debt and need to generate extra returns to pay to the equity shareholders. However, there is a source of fund called the OPM (Other People’s Money) which is available free of cost to a company.

The concept of OPM can be explained with the following examples:

Say, an apartment is rented out and the tenant pays a security deposit of Rs 1 lakh, when he vacates another tenant moves in and pays a security deposit which is then used to pay the first tenant. This goes on and on and thus, the security deposit paid by the first tenant is yours as long as you keep renting your apartment. This is known as Other People’s Money.

In the business context, your customers and suppliers are those other people.

Case of Eicher Motors

Eicher Motors manufactures Royal Enfield brand of motor bikes and Eicher brand of trucks and buses. They have over 90% of market share in the mid-weight motor bike segment. From 2011 to 2019, the sale of motor bikes increased from 74000 units to 8 lakh units. In the same period, two wheeler sales increased from 1.2 crores to 2.1 crores per year. There are long waiting lines for its bikes and consumers pay Eicher in advance.

Eicher pays its suppliers 95 days after the purchase on an average. It’s like keeping the suppliers money interest free for 95 days.

Eicher gets to keep both the customers and the supplier’s money. This leads to a negative working capital.

The OPM generated between 2011 and 2019 was enough to fund almost a quarter of the additional property, plant and equipment that Eicher spent in that time. If Eicher had borrowed this much amount than the interest cost would have been high which concludes that OPM helps to save interest expenses too.

Case of Info-Edge  

Info-edge operates popular websites like naukri.com, jeevansaathi.com, 99acres.com and has investments in several other companies, most in Zomato. Info-edge acts as a bridge between recruiters and job seekers, who pay the company in advance for its services. Info-edge gets paid more 120 days in advance for its services

However, it doesn’t need any land or machinery to grow. Thus, it has an OPM i.e. 3 times its investments in PPE.

OPM is important to shareholders because:

  • OPM is free of cost and thus helps the company avoid interest expenses leading to greater profits.
  • Presence of OPM in itself signifies the company specialty. However, that specialty must not be short lived.

Summary of “Should the RBI print money to revive the economy?”

Here is the link to the article https://www.newslaundry.com/amp/story/2020%2F05%2F08%2Fshould-the-rbi-print-money-to-revive-the-economy-its-not-as-simple-as-it-sounds?__twitter_impression=true

Due to Covid 19, government imposed lockdown in whole country due to which almost all businesses were shut down. Due to this government’s income in the form of GST declined. Foreign trade was also impacted due to which government’s income in the form of customs and other duties also declined. State government’s source of income – sales tax/ VAT on petrol and diesel – took a hit as consumption of fuel declined. Also there were no real estate transactions which means no stamp duty and as alcohol shops were also closed no taxes were collected from their too.

In such crisis times, every person share their views on how to revive economy and all have one answer – RBI will print money from thin air and will give it to government for spending. But there’s a catch here. What looks easy doesn’t mean it is easy.

There are few points which need to be taken care of. They are –

  • The money which the government is printing and distributing is just fiat money i.e. it is not backed by any commodity. Just because government says that it is money people believe and accept this as money. One more reason people accept this fiat money is that they know others will accept it (Example – ‘A’ use this money because he knows that ‘B’ will accept it and ‘B’ accept it because he know ‘C’ will accept it).  Government too create demand of fiat money by accepting taxes in home currency. The problem also lies in taxes. In India, if government reduce tax evasion then this will ensure in more demand of rupee.
  • Another point is that if government will infuse money into economy to create demand then it will lead to inflation. Because more money will be chasing the same quantum of goods. But according to survey done by RBI on capacity utilization it was found that one-third capacity is lying unused. So manufacturing companies can increase production without affecting prices (inflation).
  • Now here comes an interesting point. RBI prints money and buy government bonds. Government spends this money through which it reaches many people. These people spend this money further in buying goods/services. Through this the money reaches to corporates and they deposit it in bank accounts. Then the banks park the excess money with RBI at lower rate (if bank buy government bonds they earn 6% interest but parking with RBI in reverse repo window yields 3.75% return, according to latest rate). This also leads to lower tax collection from banks as they earn less.
  • Creating money and infusing it into economy can also lead to depreciation of economy. Foreign investors will take an exit which will lead to more demand for other currency and selling pressure on rupee will lead to a rise in exchange rates. Also, currencies of countries like United States, United Kingdom etc. have global demand. So they can print money without damaging exchange rates.

Hence there are challenges in taking this step. But at the end it’s the call of government to take decision on it.

Summary of article on “Understanding your Circle of Competence”

Here is the link of the article: https://fs.blog/2013/12/circle-of-competence/

Knowing your circle of competence enables you to avoid problems, identify opportunities for improvement, and learn from others.

Warren Buffett uses the concept of the circle of competence as a way to focus investors on the areas they knew the best.

Circle of Competence

Every person develops knowledge on certain areas through experience or study. Some areas are understood by most of us, whereas some of them require a lot more specialty to evaluate.

For example, understanding the economics of a restaurant involves renting or buying space, spending money to outfit the place and hiring employees.

However, understanding the working of, a microchip company or a biotic drug company cannot be developed by most of the people.

While investing, as Buffet says, we don’t necessarily need to understand specialized areas to invest. It is important to define what we know and to stick to those areas. Our circle of competence can be widened slowly overtime.

Charlie Munger took this concept outside of business. He said that, you have to figure out what your own aptitudes are. You cannot play games where other people have the aptitude and you don’t. This is because it is most likely that you will lose. You have to play your own circle of competence.

However, the goals must be attainable and the area within which you think you lie must be realistic. For example, being the best tennis player in the world is an unrealistic thing to start off. However, being the best plumber of a given area is a more achievable task. The key to improving your odds of success in life is by setting the correct and honest perimeter to operate within and to expand it slowly.

Summary of Article on “Asset-Liability Management”

Here is the link to the article https://twitter.com/FinsenseG/status/1259705804661256193?s=19

In this article, the concept of ALM is explained.

What is ALM?

Simple, ALM is the management of assets and liabilities. For banks, assets are the loan given to customers and liabilities are the deposit made by the customers or money raised by debt instruments like NCD’s or bonds etc.

What is a mismatch?

When banks have excess of either deposits or liabilities in a single time frame, it is mismatch. Example – A bank has deposits for 5 years but it gives loan for 20 years.  After 5 years when depositors will demand money then bank would not be in a position to pay it back and thus it will default.

Banks have to group all their assets and liabilities (according to time frame) and need to show it in balance sheet.

Some techniques used by banks for management of assets and liabilities –

  1. Gap Analysis – Interest rate risk on RSA (Risk Sensitive Assets) and RSL (Risk Sensitive Liabilities) are assessed using this method. RSA and RSL are floating rate loans or deposits or any instrument with premature mature and withdrawal option.
  2. Duration Analysis – Duration analysis is done to asses risk of interest rate fluctuation. Higher the maturity of instruments, higher is the chance of change in interest rate.
  3. Scenario Analysis – In this method, various scenarios are created to check how ALM can be affected in future. Scenarios can be like rise in interest rate, decline in interest rates etc.

Thus ALM is an important concept when it comes to risk management. Investors gain confidence if ALM is good. It can be checked in annual reports of banks/ NBFC’s.