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 But let’s assume that the spare parts of the machine are long outdated and have no value in the market.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?”

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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.

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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)

From the Vault: Looking to Invest? Game for P2P?

cash
(Source: MasterCard)

 

Imagine that you are sitting on a cash pile, with no idea on where to invest it. Well, you have a range of options. You can

1.Open an FD Account with a bank.
2.Invest in securities
3.Invest in Real Estate
4.Invest in gold

These are the traditional avenues to which you can shift your money. Logically, going by the diversification rule, your portfolio will consist of a mix of these. Why? Every option has a level of risk and return attached to it. So, a mix of these options will ensure that the risk is rewarding.

Let’s draw a risk-returns matrix and see where each option sits

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So, now where would you place your pile? On one option or many?

To most of the readers, this is elementary knowledge. You guys are probably wondering, “This is Financial Management 101! Where is she going with this?”

I agree with you guys. However, I am about to present to you a fifth option. And that is Peer-to-Peer lending. Yes, I am talking about “shadow banking”.

According to Wikipedia, “Peer-to-peer lending, commonly abbreviated as P2PL is the practice of lending money to unrelated individuals, or “peers”, without going through a traditional financial intermediary such as a bank or other traditional financial institution.”

I learnt of the existence of P2P when I received a spam mail from one of the P2P marketplace site, called Faircent.com. I decided to explore more and uncover this investment trend. Apart from Faircent, we have i-lend. There are other P2Ps in the market, but they focus on lending to companies and not retail investors/borrowers.

So, how does this model work and why will anybody choose P2P?

P2P portals help lenders meet borrowers. Lenders can choose from a list of verified borrowers on the website. They are also advised to spread their investment among borrowers to lessen the risk of default. The investment begins from INR 5k upwards and for this risk, the lenders get a return of 15%-24% on i-lend and upto 25% on Faircent. The borrowers can borrow from INR 25k to 100k at 12% upwards. The portals charge an upfront fee from both lenders and borrowers and get the borrower’s documents and employment details verified by a third party. A contract with terms and conditions is signed within a week, with a recovery process in place for those who default on payments.

What is the advantage of P2P?

Bank customers can sometimes struggle to secure bank loans because of employer credentials, salary requirements or credit history. Around INR 3.8 trillion ($61 billion) in personal loans, excluding home loans, were outstanding in March 2012, a Reserve Bank of India report shows. This includes education loans and credit card dues. Thus with bad loans mounting, banks in India have become wary of lending in certain sectors in the past few years.

Informal lending is common in India, with businessmen and family members often lending money in times of need. P2P is a progression of that, with the money flowing not from family/friends but from other like-minded people. According to a research article by Mr Ankit Shah, a Senior Associate Consultant for Finacle (Infosys), the advantage of P2P lending is the likelihood for the borrower to secure the loan at a lower rate of interest as compared to a bank loan and the likelihood for the lender to receive a better interest rate as compared to a bank deposit. P2P lending asset class is different from the traditional savings account or stock market linked investments. The only risks involved here are the counterparty risk and the concentration risk. Concentration risk can be greatly mitigated by spreading the loan amount across a large number of borrowers. As for the Credit risk, lenders can decide to lend only to borrowers having a specific credit profile, which is listed on the sites.

What is RBI’s take on P2P?

As per a Jun 2014 RBI report, “India’s ‘shadow banking’ sector essentially refers to the large number of ‘unregulated’ entities of varying sizes and activity profiles, raises concern partly because of the public perception that they are regulated. Technology-aided innovations in financial disintermediation such as peer-to-peer lending warrant a regulatory preparedness.” “While in certain regulatory jurisdictions this space is being looked at as more favorable, some other regulators have raised concerns mainly relating to distress for lenders in the event of a sudden closure of such platforms. While these platforms are still new to India and the scale of transactions is insignificant, this is a gap which requires regulatory attention. This is all the more important since in developed markets, mainstream financial market participants and products are making an entry into this space amidst concerns over regulatory arbitrage.”

What’s on the cards?

Mr Shah continues to say that, P2P lending is still in its nascent stage. With evolving models, better regulatory mechanisms and improved credit rating facility, we may see more and more lenders and borrowers participating in this new way of lending. In the coming years, it can have the depth to support a larger participation. Also, with internet users spending more time on social networks, it is likely to generate higher interest in people in the time to come.

So, if you are sitting on a cash pile, where would you place your bet? The traditional avenues or P2P?

This article was written by Vinita Jagannathan (PGDM, Batch 19, 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)