Is Investing in the Stock Market Really That Difficult?

stocks
(Source: MasteryOfWealth)

There is a theory in finance which says “The value of any asset is the sum of the present value of its future cash flows.”

Let’s take Warren Buffet’s famous Gumball Machine to explain this. Let’s say you own a gumball machine. The gumball machine gives you, after all the expenses spent on it, $100 every year as net revenue. You are about to sell this gumball machine now.

SONY DSC

How much would you sell it for? The sum of the price of its spare parts? Seems reasonable. But let’s assume that the spare parts of the machine are long outdated and have no value in the market. So, should you give it away for free? No, of course not. The gumball machine is not just about its spare parts. It gives you the additional $100 in spite of the value of its spare parts. Shouldn’t you consider that? You should. If you held on to that gumball machine for eternity (Just consider), it would give you $100 perpetually.

However, getting $100 today is not the same as getting $100 5 years later. Time erodes the Value of Money. Let’s say that the interest rate in the country is 2%. This means that, to get $100 5 years down the line, you simply need to invest $90.60 today (Approximately) i.e. 90.60*1.02^5. This basically means that the present value of receiving $100 5 years down the line is equivalent to receiving $90.60 today.

Going back to our gumball machine with the understanding of the time value of money, we can easily determine, using the perpetuity formula, that the value of the gumball machine today is $100/0.02, which is $5000. This is the intrinsic value of the gumball machine. You should probably sell the gumball machine for $5000, give or take.

Now imagine an economy full of gumball machines. Everyone’s buying and selling gumball machines and all these machines are perfectly identical. What would you do if you find a gumball machine selling at $4500? You would buy it, definitely. Because just by paying $4500, you are getting a present value of $5000. $500 profit, cool. And what if you find gumball machines selling at $6000 in the economy? You will sell your gumball machine and make a cool profit of $1000.

Easy, right? Wrong. What if you buy the gumball machine at $4500 and suddenly there’s a huge drop in demand of gumballs? And what if because of that, your yearly net revenue drops to $60 instead? You would then be sitting on a present value of $3000, making a loss of $1500. You can make every beautiful assumption and pull out well-constructed forecasts, but in truth nobody knows the future. You only expect that your average yearly revenue will be $100. It can just as easily be $150 or it can be $60.

The gumball machine can be directly related to companies. In the case of companies, the $100 can be equated to the company’s free-cash flow (Cash flow of the company after accounting for all possible expenses and debt payments), although a company’s cash flow may vary from one year to another. You discount this free cash flow to its present value, divide it by the number of shares of the company and voila! You have the intrinsic value of the company. This is the premise of valuing a company’s share.

Let’s say you project, forecast and discount the free-cash flow on XYZ Company and arrive at the figure $25. This means that the price of XYZ company should tend to $25 in the share market. But you will find that this is not usually the case. The market is made up of millions of people and not everyone does a DCF Analysis of the stock before buying or selling it. They act on impulse and news, mostly. You might have figured out a really golden company, but if the majority of people in the stock market are not interested in the stock, it would barely move. Or quite simply, your projections and assumptions in the initial valuation phase might have been wrong.

“The markets can remain irrational longer than you can stay solvent.”

Also, a company’s share price is not all about numbers. It is also largely dependent on the company’s competitive position in the market, the company’s management and so many other fundamental factors, which need expertise to understand. Most people in the stock market may not care about this at all.

On top of all this, there is always the stark truth that the unpredictable can happen at any time. Take a look at the following graph of the historical price movement of a famous company’s share. Forget all the mathematical calculations and try to answer from instinct: “Will you buy this company’s share?”

EN1

If past performance was an indication of the future, you would be inclined to say “Yes”. I mean, heck, many Ivy-league educated Wall Street investors said “Yes”. That’s why the share price has increased sharply towards the end of the graph. But can you guess which company this is? It’s Enron.

EN2

Nobody knew Enron would get caught in the Accounting Scandal the way it did and nobody knew that it would wipe out the company. The most intelligent investors got out of Enron real fast, sure. But the the scandal caught everyone off-guard. Such events can happen to any company. At such times, it is only your expertise of in the business of the company that will help you determine if you should buy more of the stock or sell it. The shares of many big companies lost 50–60% of their value immediately after the 2008 crisis. If you’d invested in any of those companies, for instance GE or Goldman Sachs, for instance, you would be reaping profits now (You can look at their historical price movements in sites like Bloomberg).

So to answer the question, it is not difficult at all to determine the fair price (The price at which you are willing to buy) of a company’s share. It is, however, difficult to understand human beings. And human beings determine the market price (The price at which you can sell) of the company’s share. It takes years of expertise, patience and determination to make a huge profit out of the share market.

This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)

The Saga of the Stock Market

The following is a story of how a room full of men shouting at each other, fighting with each other to buy neatly printed paper became one of the most important economic activities of the twenty first century.

 

What is a Stock Market?

 

In simple words a Stock market is a place where stocks, bonds, options and futures, and commodities are traded. Buyers and sellers exchange trade together via platform provided by stock exchange through computers. Trades are done during specific hours on business days Monday to Friday. Stock markets are some of the most important parts of today’s global economy. Countries around the world depend on stock markets for economic growth.

 

stockexchangepicture
(Source: CoddingCapital)

 

Early stock and commodity markets

The evolution of the stock market started from 12th century From France. They had a system where ‘courretiers de change’ managed agricultural debts throughout the country on behalf of banks. Then in 13th century ‘Merchants of Venice’  also started trading in Government securities. Later on in 14th century bankers in Pisa, Verona, Genoa and Florence also began trading in government securities. Italian companies were the first to issue shares. The first genuine stock markets didn’t arrive until the 1500s.

Stocks Cafe

Evidences shows that early stocks were handwritten on sheets of paper, and investors traded these stocks with other investors in coffee shops due to the fact that investors would visit these markets to buy and sell stocks. Nobody really understood the importance of the stock market in those early days. People realized it was powerful and valuable, but they were having no idea of exactly what it would become.

That’s why the early days of the stock market were like the Wild West. In London, businesses would open up overnight and issue stocks and shares of some crazy new venture. In many cases, companies were able to make thousands of pounds before a single ship had ever left harbor.

There was no regulation and few ways to distinguish legitimate companies from illegitimate companies. As a result, the bubble quickly burst. Companies stopped paying dividends to investors and the government of England banned the issuing of shares until 1825.

Evolution of the NYSE and LSE

Despite the ban on issuing shares, the London Stock Exchange was officially formed in 1801. Since companies were not allowed to issue shares until 1825, this was an extremely limited exchange. This prevented the London Stock Exchange from becoming a true global superpower.

That’s why the creation of the New York Stock Exchange (NYSE) in 1817 was such an important moment in history. The NYSE has traded stocks since its very first day. Contrary to what some may think, the NYSE wasn’t the first stock exchange in the United States. The ‘Philadelphia Stock Exchange’ holds that title. However, the NYSE soon became the most powerful stock exchange in the country due to the lack of any type of domestic competition and it’s positioning at the center of U.S. trade and economics in New York.

The London Stock Exchange was the main stock market for Europe, while the New York Stock Exchange was the main exchange for America and the world.

 

History of the Indian Stock Market

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To study the history of the capital market in India we have to look back in the eighteenth century when East India Company started security trading in India. Security trading in India was unorganized during that time. Two chief trading centers were Calcutta and Bombay. Out of them Bombay was main trading port. During American civil war (1860), Bombay was the important center where essential commodities were traded. Because of heavy supply those days prices of stocks enjoyed boom period.  

Probably, the first Indian Stock Exchange’s boom period. It lasted for almost 5 years. After those booming period Indian stock exchange faced the first bubble burst on July 1st 1865. During that time trading in stock market was just a concept, a thought, an idea. It was limited to 12-15 brokers only. There market was situated under a banyan tree in front of the Town hall in Bombay. These brokers organized an informal association, in 1875. Name of the association was “Native Shares and Stock Broker Association”. Very few visionary could feel that it was starting of the great history of Indian stock exchange. After 5 decades of the incidence, the Bombay stock exchange was recognized in May 1927 under the Bombay Security contracts Control Act, 1925. But still the exchange was not well organized as British Government was not willing to see India as a rising nation. 

After independence, 1st priority of the Indian government was development of the agriculture and public sector undertakings. In first and second five year plan, capital market was not a goal for Indian government. Moreover, the controller of capital issues closely controlled many factors for new issues. It was one reason and big enough to de-motivate Indian corporate to stay away from the idea of going public. 

In 1950s, some good companies listed in the exchange were brokers’ favorite. Some of them were Century Textile, Tata steel, Bombay dyeing, and Kohinoor mills. They were favorite not because of any technical or fundamental reason. The brokers enjoyed trading in these scripts as it was operated by operators. Slowly the stock exchange was given one new name “Satta Bazaar”! But surprisingly, despite of speculation, default cases were very few. In 1956, the government passed the Securities Contract Act. 

In 1960s, Indo China war happened. This was starting of bearish phase in stock exchange. Financial institutes helped to boost the sentiment by injecting liquidity in the market. In 1974, 6th of July was the day when capital market got one bad news. Government introduced the Dividend Restriction Ordinance as per which companies cannot pay more than 12% or 1/3rd of the profits. Stock market crashed again. Stocks went down by 20% and the market was closed for nearly a fortnight. The sentiment of stock market was same until the optimism came in market with when the MNCs were forced to dilute majority stocks in their company in favour of Indian public. Many MNCs left India. But there were around 123 MNCs who offered shares lower than its intrinsic value. It was the first time Indian public had opportunity to invest in some of the finest MNCs.

 In 1977, Mr Dhirubhai Ambani knocked the door of Indian stock exchange and it was probably the turning point not only for Indian stock exchange but for Indian economy.In 1980s, Indian stock exchange witnessed phenomenal growth period. Indian public discovered lucrative opportunities in stock exchange. It was the time when people who did not even know what is stock exchange is, started investing in the same. The growth doubled with the government liberalization process in mid 1980s. It was the time when convertible debentures and public sector bonds were popular in market. New stock market entries like Reliance and LNT re-defined Indian stock market scenario. Such factors enlarged volume in stock exchange. 1980s can be characterized by huge increase in the number of stock market, listed companies and market capitalisation. 

The 1990s can be described as the most important decade in the history of Indian stock market with liberalisation and globalization being in the air. The Capital Issue Act of 1947 was replaced in 1992. SEBI was emerged as a new regulator of the market. FII came to India and re-rated India as one of the most attractive market in world. Stock exchanges numbers rose  in country.

The Bombay stock exchange had two new competitors in market. OTC (Over-The- Counter) was established in 1992 and NSE was established in 1994. The national security clearing corporation (NSCC) and National Securities Depository Limited (NSDL) were established in 1995 and 1996 respectively. In 1995—1996 Option trading service was started. Number of participations in stock exchange was rising with new segments for trading, new products and new technology. 1990s is known as era of Indian IT companies too. Wipro, Infosys, Satyam were some of the favorite stocks. Telecom and Media sector also rose during the same time. 

In the 2000s, FII money started coming in Indian market like never before. NSE volume crossed the BSE trading volume during the same time. And the Indian stock trading scene would never bet the same.

 

This article was written by Varnita Deep (PGDM, Batch 22, XIME-B)

Investment Gyaan from the Oracle of Omaha

Warren Buffet, also called “The Oracle of Omaha” is known world-wide for being super-rich. But more than his ascent to a luxurious life, his simple and sometimes whimsical gyaan on investment is what’s most sought after by aspiring investors. Here, we will see 10 of his time-tested investment wisdom and what they mean.

 

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(Source: Entrepreneur)

 

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

 

The stock market is made up of people who want to sell stocks and those who want to buy stocks. Whatever price the buyer agrees to pay for a stock becomes the stock’s price. What Mr. Buffet is trying to say here is that, even if the market shut down for 10 years, provided you are holding the stocks of a very good company, it would still be profitable when the market re-opens, that is to say, people would be willing to pay a bomb for the share you bought at a considerably low price.

 

“Successful investing takes time, discipline and patience. No matter how great the talent or effort, some things just take time: You can’t produce a baby in one month by getting nine women pregnant.”

 

One very good long-term investment is better than several mediocre short-term investments.

 

“Price is what you pay. Value is what you get.”

 

This quote summarize the entire ‘value investing’ strategy of Mr. Buffet. The price that you pay to pick up a stock is the money you are willing to commit in order to obtain all the future cash flows of the business to the extent of your stake in it. Make sure that this additional ‘value’, or the returns in excess of your expectations, provided by the company is well worth the money you are committing to the business.

 

“Be fearful when others are greedy. Be greedy only when others are fearful.”

 

When people buy stocks just because everyone else is buying, the stock becomes overvalued and becomes a bad investment. On the flip side, panic selling of a stock opens up opportunities for the long-term investor to purchase good companies at a cheaper price, therefore increasing their returns. Look forward for these opportunities.

 

“Risk comes from not knowing what you’re doing.”

 

More than anything else, Mr. Buffet emphasizes on investing in businesses that the investor understands. Legend has it that once Bill Gates approached Buffet to convince him to invest in Microsoft, which had some operational issues at that time. Buffet politely declined, stating that he has no knowledge of computers. Imagine telling “no” to business of the richest man in the world! But as an iron rule, a good investor should only invest in businesses he knows in-and-out.

 

“It’s only when the tide goes out that you learn who has been swimming naked.”

 

When everyone is spending in the economy and every business seems to be doing well, it is hard to differentiate a good business from the bad. Only during times of crisis, you can figure out which businesses close shop and which survive. A good businesses always survives.

 

“Do not save what is left after spending. Instead, spend what is left after saving.”

 

The saving habit is the crucial difference between a good investor and a bad investor. You may create mountains of wealth, but if you do not have the habit of saving, there’s a good chance that the wealth will be eroded eventually.

 

“Forecasts tell you a great deal about the forecaster; they tell you nothing about the future.”

 

In investment, the ‘fundamentals’ (Qualitative factors) of a company have a much higher weightage in determining its value than the ‘technicals’ (Quantitative factors). In fact, good fundamentals automatically lead to good technicals.

 

“I try to buy stocks in businesses that are so wonderful that an idiot can run them because sooner or later, one will.”

 

Invest in a business because you believe in the core-competency of the business and you believe that they can maintain it for a long, long time. Don’t invest in the business because the current CEO is an inspirational person. The CEO can be and will be replaced. The core competency stays with the business.

 

“What we learn from history is that people don’t learn from history.”

 

Change is the order of the day. History may repeat itself, but it definitely does not repeat itself in the same manner. Reading the past information of a business is important, but the winning trick is in understanding what the past information means for the future of the business.

 

Albert Einstein once said “Everything should be as simple as possible, but no simpler.” How fitting it is to Warren Buffet’s case!

 

This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)

A Layman’s View of the Goods and Services Tax

GST
(Source: FosterGem)

 

The Goods and Services Tax (GST) is the biggest reform in India’s indirect tax structure since the economy began to expand 25 years ago. At long last, a dream is set to become reality. The 122nd Constitution Amendment Bill came in Rajya Sabha with a broad political consensus (And the “good wishes” of the Congress Party), which holds the crucial cards on its passage.

 

GST is a single indirect tax for the whole nation, which will make India a unified common market. GST is a single tax on the supply of goods and services, right from the manufacturer to the consumer. Credits of input taxes paid at each stage will be available in the subsequent stage of value addition, which makes GST essentially a tax only on value addition at each stage. The final consumer will thus bear only the GST charged by the last dealer in the supply chain, with set-off benefits at all the previous stages.

 

In other words, the prices that we pay for goods and services have the taxes embedded in them. Mostly, the consumers are not even aware of or they ignore the tax they pay for things they buy. This is because there are plethora of indirect taxes such as sales tax, excise and VAT, which leads to increased complexity. The GST seeks to untangle this knot and subsume all in one single tax, thereby making India an economically unified market.

 

The Empowered Committee of State Finance Ministers, which deliberated on the tax and its implications, has recommended what taxes are to be subsumed in the GST:

 

In the Central Taxes:

1) Central Excise Duty;

2) Additional Excise Duties;

3) The Excise Duty levied under the Medicinal and Toiletries Preparation Act Service Tax;

4) Additional Customs Duty, commonly known as Countervailing Duty (CVD);

5) Special Additional Duty of Customs – 4% (SAD);

6) Surcharges, and

7) Cesses.

 

Among the State Taxes and Levies:

1) VAT / Sales tax;

2) Entertainment tax (unless it is levied by the local bodies);

3) Luxury tax;

4) Taxes on lottery, betting and gambling;

5) State Cesses and Surcharges in so far as they relate to supply of goods and services; and

6) Entry tax not in lieu of Octroi.

 

For Example :

Assume that the cost of raw material is Rs. 100.00. The tax rate is assumed to be 10% for all taxes.

 

Under the CENVAT System:

On the Rs. 100.00 raw material, the manufacturer pay Rs. 10.00 as tax. The manufacturer adds Rs. 20.00 value. To this the manufacturer adds Rs.2.00, which is the CENVAT or Central Value Added Tax. In the example, the CENVAT is assumed at 10% of the Rs. 20.00 value added by the manufacturer. So the cost for the retailer is Rs.132.00 [Rs. 100.00 (Raw Material) + Rs. 10.00 (Tax on Raw Material) + Rs. 20.00 (Manufacturer Value Addition) + Rs. 2.00 (Tax on the Value Addition)]. When the retailer sells it to the consumer, he adds his own margin at Rs. 20.00. This takes the price to Rs. 152.00. Add 10% Sales Tax to this, which increases the price to Rs. 167.20. Thus the final price the consumer pays will be Rs. 167.20. Of this final amount, the taxes paid by the consumer is Rs. 27.20.

 

Under GST:

In GST, a Value Addition Taxation system is followed. This means each person pays tax only on the Value Added at that point. In our example, when the retailer sells the tax is applied only on the margin of Rs. 20.00 and not on the Rs. 132.00 which is the cost paid to the manufacturer. So the tax the consumer pays is considerably (~48%) lower at Rs. 14.00 [Rs. 10.00 (The tax paid by manufacturer when the raw material was bought) + Rs. 2.00 (The tax on the manufacturer’s Value Addition) + Rs. 2.00 (The tax paid on the margin of the retailer)]. The ultimate effect is the reduction of the end consumer’s (The common public’s) tax burden.

 

In other words, under the current CENVAT system, there is a cascading effect or double taxation i.e. the consumer pays tax on the tax already paid by the manufacturer. The GST circumvents this problem completely. Below is another example of a fully worked-out difference between the CENVAT system and the GST system.

 

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(Source: ICICI Bank Research)

 

Know your GST

 

The GST Council

The GST Council will consist of the union Finance Minister (chairman) and MoS in charge of Revenue; Minister in charge of Finance or Taxation, or any other Minister, nominated by each state. Decisions will be made by three-fourths majority of votes cast; Centre shall have a third of votes cast, states shall together have two-thirds mechanism for resolving disputes arising out of its recommendations may be decided by the Council itself.

 

 

The Levy of GST

Both Parliament, state Houses will have the power to make laws on the taxation of goods and services. Parliament’s law will not override a state law on GST exclusive power of The Centre to levy, collect GST in the course of interstate trade or commerce, or imports. This will be known as Integrated GST (IGST). Central Law will prescribe manner of sharing of IGST between Center and states, based on GST Council’s views.

 

What’s Out of GST?

Alcoholic liquor for human consumption, Petroleum crude, high speed diesel, motor spirit (petrol), natural gas and aviation turbine fuel (The GST Council will decide until when).

 

And What’s In?

Tobacco and tobacco products (The Centre may impose excise duty on tobacco).

 

What has happened so far?

Budget 2006-07: GST by April 1, 2010, announced. Subsequently, Empowered Committee (EC) of state Finance Ministers tasked with drawing up road map and design.

April 2008: EC, headed by the then West Bengal Finance Minister Asim Dasgupta, submits report to the central government, which offers its views and comments in October and December of that year. Joint working groups are then set up to examine options on exemptions and thresholds, taxation of services and inter-state supplies etc.,

November 2009: EC releases its First Discussion Paper.

March 22, 2011: The Constitution (115th Amendment) Bill is introduced in the Lok Sabha; is referred to Parliamentary Standing Committee on Finance, which submitted its report on August 7, 2013. Bill lapsed as term of the Lok Sabha ended in 2014.

December 19, 2014: Constitution (122nd Amendment) Bill introduced in Lok Sabha.

May 6, 2015: Constitution Amendment Bill passed by Lok Sabha.

May 12, 2015: Bill referred to a 21-member Select Committee of Rajya Sabha headed by Bhupender Yadav.

July 22, 2015: The Committee submits its report.

Monsoon and Winter Sessions 2015, Budget Session 2016: Bill not tabled in the face of opposition led by the Congress and persistence of sticking points.

 

What’s Ahead?

The President shall constitute the GST Council. The GST Council shall make recommendations on:

1) Taxes to be subsumed
2) Exemptions
3) Model GST laws, Principles of Levy, etc.
4) Threshold for exemption
5) Rates, including floor and bands
6) Special rate/rates for specified period
7) Date from which GST to be levied on crude, high speed diesel, natural gas, aviation turbine fuel and petrol
8) Special provisions for the Northeast, J&K, etc.

 

Parliament will pass a legislation on Central GST (CGST) and Integrated GST (IGST). All the 29 states and 9 UTs will be asked to pass their state GST (SGST) Acts. Dates of implementation of CGST, SGST and IGST have to be negotiated and synchronized.

 

Some States will initially act up. The GST will give them short term losses. For instance, the aggregate tax amount collected by the Tamilnadu and Maharashtra governments under the current CENVAT and State Taxes system is much higher than what they would get out of GST once it is implemented. This is owing to the fact that these states are net manufacturers of goods and services. The Centre has promised to compensate such states with a higher percentage of the net tax proceeds. Hopefully, that will calm them down. Gradually, they too will be brought under the broad umbrella of GST.

 

This article was written by Varnita Deep (PGDM, Batch 22, XIME-B)