Sunday, April 26, 2009

Stock Market: Act like Poor to Become Rich

The world as a whole has to be thankful that we have witnessed one of the worst crises (Crisis) in history without which, the act of unjustified greediness by investors would have continued for more years. The situation was not different with general population either. People spent money on luxury things far more than what they were capable of while the situation warranted economical prudence. I wondered who all survived this crisis and the answer is relative rather than specific as most of us survived except few suicides. But, some people managed the situation better than the rest and I would like to draw a parallel between this general life and stock market.



India has managed this recession better than most of the countries purely because of the saving mindset cultivated from childhood and also the conservative strategy followed by corporate world. But in US, a person with even $35,000 income went for 3 bedroom single home property and even worse is on the part of the banks that financed him charging higher interest rates without dwelling much on the repayment capability. Any man with a common sense would tell that the lower income people should be provided loans with lower interest rates but I still fail to understand the logic behind the US banks charging higher interest rates from low income group. I of course know that charging higher interest rates to low income people would prevent them to approach a bank for financing. But if it is not working, then there should be some alternate strategy which US banks lacked and still they do. As you know, getting a loan in India is not that easy and definitely not as easy as in US. The result is there for everyone to see that Banks survived and people survived too.

People who continuously saved some money and lived decent but economical life, have not only managed to survive but managed to live as normal as ever. Those who went for luxury beyond their financial capability failed miserably and no wonder all those who committed suicide have lived in 5 bedroom luxury villas. But what is the parallel here? Why I am talking about all these in a stock market blog?
We give so much importance to quality and the price in almost all the things we buy whether it is buying a home or car or vegetables or anything for that matter. But do we give the same importance while buying stocks? I do not think so if the recent rally is taken as an example. I am not saying that buying now would be a mistake as prices are still lesser than what it was one and half years back. But I am just asking why we did not buy when the prices of the stocks were lesser than what it is now? It seems people are ready to buy even a cup of garbage if there is a rumor that it would turn as gold in few years.

Buying stocks at lower prices not only gives you better returns but also protects you from capital loss. SENSEX was around 8000 in the First week of March and I was compelled to buy stocks because of the valuation and was even compelled to post an article with best stocks. I posted “Best Indian stocks for Long term investments” on March 14, 2009 and here is the link for that.

http://www.stockanalysisonline.com/2009/03/best-indian-stocks-for-longterm.html

Majority of the stocks have returned more than 30 % returns and some of them giving more than 50 % returns. I also posted another post with “Best Small cap stocks” on March 18, 2009 and the link is given below.

http://www.stockanalysisonline.com/2009/03/best-small-cap-stocks-india-2009.html

Majority of the stocks listed in the above link has given more than 100 % returns and it is unbelievable. The mid and small cap stocks have given extraordinary returns in this rally in such a short time. How many people bought stocks when the SENSEX was around 8000? If you ask me, Yes, I bought some but not enough to tell you that I have achieved something in stock market. But I am happy that I bought something at least. So, my point here is, why people show due diligence in price while buying household and other articles but do not show same kind of prudence in buying stocks? When people go out for shopping, they try to reduce the price as much as they can but not in case of stocks. I do not know if people would have avoided buying if there was a furniture or cloth sale with 1/8 of the price. Stocks were so cheap and many small and mid caps were available at 1/8 or 1/10 th of the price a year ago and most of the retail investors avoided it. People can ask if there was no buying then how the market went up. Market went up not because of retail investors but because of Mutual Funds, Insurance companies and Institutional Investors. May be the retail investors who bought mutual funds exactly in the first week of March, 2009 would have benefited to an extent but definitely not to an extent of what they would have got if they had bought stocks during the same period.

So, here is my rule number one.
Rule 1: Buy stocks (Of course good companies) without any hesitation whenever market is unjustifiably low. If you are in doubt, just ask yourself if you would buy cloths or furniture or laptop or house if the price is lowered 1/8 th or 1/10 th of the original price. If the answer is yes, then you should go ahead and buy stocks whenever it is available at extremely low prices. In essence retail investors should act like poor while buying stocks. If you act like poor and buy stocks, only when it is available at extremely low prices, then I do not think there is any need for analyst advice or recommendation. You just need the guts to do that.

Reason:
1. Extraordinary profit when the market is up.
2. Limited downside potential.
3. Some protection even if you have bought bad stocks.


Recent Rally

It is true that SENSEX has moved 40 % higher than what it was 6 weeks back. I feel that’s more to do with abundance of cash with fund houses and institutional investors rather than any fundamental difference in the economy. We are still getting bad news around and companies are still posting average quarterly returns with poor future guidance. Unemployment is still raising and housing market is still getting worse. Credit card default is mounting. But why the heck stocks markets moved up so fast? Of course some companies have exceeded market expectations but those are exceptions rather than rule.
I have a feeling that the market has gone up so fast and it is not a healthy sign. If the market has gone up in a measured way, then we can be sure of its upside. May be a 20 % upside in such a short time would have been appropriate given the future economic growth expectations. But 40 % in such a short time does not offer any clue to retail investors about upside or downside. Moreover it gives false hope to people and retails investors start buying after mutual funds and institutional investors create almost an artificial upside in the market and eventually they stand to lose money when the market pulls back to healthy numbers. I might be wrong here and markets might move up continuously from here on and I even wish so. But over heating market always destined to get cooled off and investors have to be at least cautious if they can’t resist buying at the peak of a rally like this. So, here comes my rule number two.

Rule 2: Do not buy stocks if the market goes up (Rally) too quickly in too short time. If you can’t resist buying in the rally, at least be cautious and safeguard your investments by investing in good stocks that has not over heated. Buying at the peak of rally might minimize the net returns over the long term.

Reason:

1. To safeguard the investments from a potential fall
2. To Maximize the net returns in the long term
3. Some protection from buying artificially inflated stocks

Earnings and Economic Outlook - March 2009

Many companies have announced the quarterly results and overall the results have been mixed. Some companies have posted very good returns and some companies have announced average returns. But when compared to other countries, Indian companies have done really well and the economic outlook with respect to India looks good.
Had Infosys, TCS, ICICI and Reliance announced the similar kind of numbers just for sake two months back, SENSEX would have gone even to 7000 level. Since the market sentiment has improved, average and even bad results do not have much impact on stock prices. Stocks are moving higher and higher even with poor guidance and thats what happens when the sentiment is positive. But considering what the corporate world is experiencing around the world, Indian companies have done remarkably well. Overall economic outlook for India looks positive and any significant downside in the market from current levels (11300) should be a buying opportunity.
Kumaran Seenivasan

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Sunday, April 19, 2009

Balance Sheet Analysis and Stock Selection

Among financial statements of a company, balance sheet is the one that attracts the attention of most large investors. But for some reason, retail investors and even some of the analysts ignore financial statements including the balance sheet and give much importance to earnings. True those earnings is an important criteria to look at but balance sheet is the one which can tell us about the company’s ability to fund for its future growth along with the debt and inventory details. Reading the balance sheet is crucial to understand whether or not the company we are investing in is capable of generating real value to the shareholders. Let us discuss in detail about the balance sheet and its importance in stock selection.
What is Balance Sheet?

A concise report or statement that gives us details regarding the company’s assets, liabilities and net worth is what we call it as balance sheet. Understanding the balance sheet will give us clear picture regarding the liquid assets of a company which can be cashed in no time in case of emergency funding or fall out.
Sample Balance Sheet Structure


Components of Balance Sheet

1. Assets Section which includes two sub sections namely current assets and long term assets.


2. Liabilities which again includes two sub sections namely current liabilities and long term

liabilities.

3. Capital or Equity section

It is called as balance sheet because asset section has to be balanced by the sum of liabilities and capital section.

Total Assets = Total Liabilities + Shareholder’s Equity or Net Worth

Now let’s see one by one.

Assets

Assets of the company include the following.


1. Cash and Cash Equivalents like Bonds, Certificate of Deposits, and Fixed Deposits etc.
2. Accounts Receivable
3. Inventory
4. Non-financial assets like buildings, infrastructure, equipments, patents and goodwill.

While cash and cash equivalents, accounts receivable and inventory are considered to be current assets, non-financial assets are usually termed as long term assets.

Current Assets

Assets that can be converted in to cash in less than 6 months fall under this category. Current assets are the ones that a company relies on to fund its day to day operations and immediate cash needs. As we know cash and cash equivalents are ready made cash components of a company. Accounts receivables are the ones which a company expects from its clients in the short term. Inventory includes products or services of a company that’s readily available to be sold. All of these are considered as current assets due to the fact that these are readily available or can be converted as cash within 6 months time period.

Long Term Assets

Assets like Buildings, Infrastructure, Equipments, Patents and goodwill are considered as long term assets as converting them into cash takes more than one year time period. Among these, Buildings, Infrastructure and Equipments are considered as tangible assets (Physical in nature) while patents and goodwill are considered as intangible assets (Not in physical form).

Total Assets = Current Assets + Long Term Assets

Liabilities

Anything that a company owe to others is considered as liabilities and can be further divided into current liabilities and long term liabilities based on the time period of the loan.

Current Liabilities

Debt that has to be paid within 6 months or 1 year time period is termed as current liabilities. Accounts payable and current borrowing / short term loans are the ones we see usually in the balance sheets under current liabilities. One company’s account payable amount goes to another company’s account receivable amount. Income tax of a company might also come under this category. In essence anything that has to be paid within a year comes under current liabilities.

Long Term Liabilities

Debt that can be paid beyond 1 year time period is termed as long term debt. Long term loans usually come in this category.

Total Liabilities = Current Liabilities + Long Term Liabilities


Equity / Capital

Capital or Equity is the amount that a company invested in the business. Companies usually report the par value of stocks in the balance sheets as equity capital and not the market value. For example if State Bank of India has total of 1000 shares and the par value is Rs. 10 then they report only Rs. 10000 and not the Current market value of the stocks. We also see retained earnings in this section which is company’s earnings minus any payout to shareholders (Dividend and Buy back). Some companies report capital in excess of stock which is an additional amount that a company gets in issuing stock in excess of the par value.

If we add equity with total liabilities, the sum should match the total asset value.

We have discussed enough regarding the balance sheet components and it’s time to look at things which we really need.

Important things to consider from Balance Sheet

We can calculate lot of different ratios and numbers from the balance sheet but I would like to present only 4 important things which we really need.

Current Ratio


If we divide the Current Assets by Current Liabilities, we get this Current Ratio which is really useful to understand how well the company is capitalized in the short term. Usually if a company has the current ratio of 1.5 – 2 or more, that’s sufficient to meet the short term obligations. But comparing this ratio among the peer group might shed more light. Because if a company has the ratio of 10 then that means, the company is sitting on huge cash and is not properly utilizing it while the company with a ratio of 0.5 is sitting on short term debt and can be vulnerable at any time. Hence, comparing the ratio with peer group helps to select the best positioned company in terms of present and future.

Debt / Equity Ratio


We can get the Debt / Equity ratio if we divide the Total Liabilities by Shareholder Equity. Lesser the number better the stock. Suppose if Airtel has the DE Ratio of 0.3, then that means Airtel is not burdened by debt concerns. If DE Ratio is less than 1, then it is widely considered a good number. Sometimes, we might need some information from income statement as well to calculate this DE Ratio.

Quick Ratio


Quick Ratio = (Current Assets – Inventories) divided by Current Liabilities. Quick Ratio is calculated to understand whether the company is depending on its inventory for immediate cash needs. This is more applicable to FMCG and Retailing companies. Quick Ratio in excess of 1 is usually enough for a company to pay for its immediate cash needs.

Working Capital

Working capital can be arrived at by subtracting Current Liabilities from Current Assets and it can be either positive or negative. Higher the number, it is better for the company. Working capital is the single important source for a company to fund for its day to day operations and for future growth. If a company has ample working capital then that should be in a good shape. Some people divide the working capital by market capitalization to see the company’s hidden value. Suppose Pantaloon has working capital of about 10 Crores and its Market cap is 20 Crores, then Working Capital Ratio is 0.5 or 50 % (10/20). This ratio simply tells that 50 percent of Pantaloon’s market cap is backed up by its working capital which is a dream number. We can think in another way as well. If pantaloon has to go out of the business for some reason, then shareholders stand to receive 50 paisa for every one rupee from the working capital alone.

These are the important things one should consider in analysing a balance sheet. But depending on the knowledge and skills, one can calculate few other ratios and numbers.

Where do we get the Balance Sheet of a Company?

We can get it from the company website under the “Investor Relations” section. Alternatively we can get it from brokerage sites.

Kumaran Seenivasan.
http://www.stockanalysisonline.com/

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Sunday, April 12, 2009

Mortgage Backed Securities and Loan Selling

Continuing from where I left in my last post, I would like to explain in detail about the Mortgage Backed Securities (MBS) and why Banks sell loans at all. I have received the following questions from one Amol and my answers follow.

Do the Banks get a cut by selling loans and why do they sell Loans?

Yes they do. They get commissions by selling loans. I do not know the exact percentage of commission they get but I think it is somewhere around 1 percent of the loan amount they sell. Suppose if Bank of America sells 1 Billion dollar worth of Loans to Fannie Mae, then Bank of America might get around 10 Million dollars (1 %) as commission. The following example shows why banks sell loans.

As I said in my last post, Banks sell loans to mobilize more capital and it is an easier form of capital generation than other available options. So, if they sell loans, then they can free up more capital to lend similar loans to more customers. Apart from that they get commission upfront which is more profitable than what they get through interest rates if they keep the loans with them.

Example: Assume Bank of America has 1 Billion dollars worth of housing loans and they have given those loans at an average interest rate of about 6 percent. If they keep the 1 Billion dollars worth of loans in their books and get interest income, then they would make about 60 Million dollars of income for that particular year. But if they sell the 1 Billion dollar worth of loans to Fannie May, they get two advantages. One is they get 10 Million Dollar commission and the other is 1 Billion Dollar loan amount which they can loan it again to customers. So, if they repeat this process once in a month, then at the end of the year, they would make 120 Million dollars in commissions alone apart from loaning 12 Billion dollars to customers. So, by selling loans Bank of America makes an additional profit of about 60 Million dollars apart from attracting more customers (Because BOA has distributed 12 Billion worth of Loans). Hope now it is clear why Banks sell loans.


What do you mean by "Banks sell loans as securities"?

This is again the same concept like shares. Take the same example given in the first question. Bank of America sells 1 Billion dollar worth of loans to Fannie Mae. Like bank of America, there are thousands of other Banks that do the same. Fannie Mae collects all these loans and remember Fannie May pay to all the Banks. So, Fannie May is no cash machine to create money. Hence, they also depend on private investments. Hence, what they do, they just pool all these loans and make it as an investment portfolio just like a company. Where does the investment portfolio get earnings? From high interest rates paid by subprime customers. So, the investment portfolio issues securities just like shares that can be traded in the secondary market and many private investors invest in it including Investment Banks, Insurance Companies, Fannie Mae, Freddie Mac, Hedge Funds and Mutual Funds. All these companies invest in mortgage backed securities because of high earnings potential but it also comes with extreme risk. As you know, when people lost jobs, they started defaulting the loan amount and all the mortgage backed securities bought by companies like Lehman Brothers became worthless and the rest is history.


In sub prime crisis, loans were sold many times by many players. So first thing that comes in my mind is why someone would buy a loan?

As I said in the previous questions, the loans were converted in to secondary market tradable securities. Remember all these subprime loans attracted exorbitant interest rates like 18 % to 20 % taking advantage of the customer’s poor credit history. So, investors started believing that Mortgage Backed Securities would give exceptional returns and invested in it. They bought loans to make more money and lost all of them.

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Sunday, April 5, 2009

Mark to Market Rules Change and Current Market Euphoria

Stock Markets around the world have been berserk with the positive economic news and mark to market rule changes announced by the Financial Accounting Standards Board (FASB). But not many people are familiar with what mark to market stands for and I would like to present my understanding about the same in simple terms. Before I get into it, I request one particular reader whose name I do not want to disclose, not to conceive my article ideas and publish it in another blog with some modifications. It undermines both my hard work and your ability to write on your own. I see the same topics getting published in another blog just one or two days after I post it in my blog which is painful actually.





Mark to Market

Mark to Market is pricing the value of assets based on the current market value and in theory it is as simple as that. But in practice, it is lot messier and in fact can play havoc with the banks ability to withstand as a business entity. If the assets are very liquid and are traded in the exchange on daily basis then, those assets can be very easily priced based on the current market value.

But if the assets are illiquid and are not traded in the exchange on a daily basis, then it becomes more difficult and those assets are not priced based on what the Bank paid initially or what the Bank would get in future but they are priced on the basis of financial models. Perfect example of this is Mortgage Backed Securities (MBS) and readers are very familiar with this term as it has played a major part in the current financial crisis. What are Mortgage Backed Securities?


Mortgage Backed Securities

According to Securities Exchange Commission (SEC), Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Let me explain in brief.

Banks and other mortgage institutions give loans to people for the purpose of buying homes. These loans (Debt Obligations) are then sold to governmental, quasi-governmental and other private entities. They in turn pool all these loans and issue securities that depend heavily on the principal and interest payments made by the borrowers who took the loans. When the borrowers default on their loans, these mortgage backed securities become worthless and that’s how Lehman Brothers, Freddie Mac and Fannie Mae, all went down.

Why do banks sell the loans?

Banks sell it to mobilize more capital and it is an easier form of financing than other available options.



Now let’s come back to Mark to Market practices and see how it affects the accounting. As I said, Banks sell these loans as securities. But when the housing crisis began (Loan default), the market for all these securities vanished and the balance sheet of most of the Banks were flooded with worthless mortgage backed securities. Based on the previous Mark to Market practices (Before April 2, 2009), Banks were forced to assess the value of the assets on current market value and Banks had to effectively write off all these worthless securities in billions of dollars from their balance sheet that took huge amount of capital away from them. After all Shareholders equity is the difference between assets and liabilities of a company.

So, most of the banks lobbied with US Congress to ease the Mark to Market accounting practices and on April 2, 2009, FASB announced that Banks can now follow flexible rules with respect to the same. According to FASB, Banks can now value the assets more strictly during good times and with lesser standards during crisis times.

How the Rule Change affects the Bank Stocks?

Based on the FASB Suggestion, if the Banks apply lesser standards, then they will be able to show billions of dollars of more assets in their balance sheets and the stock markets reacted positively to this news. God save investors. Because, this does not really solve the underlying problem of toxic assets. Banks can make their respective balance sheets look better to the eyes but what to do with all these worthless securities? This rule change will not work in long term and masking these toxic assets will again come back and haunt everyone sooner than later. It’s true that US Treasury Secretary Tim Geithner plans to rebuild a market for the assets by handing private investors cheap credit so they can start buying them up but I do not know how many private investors will take that risk of buying extremely risky securities even with cheaper credit from Government.



Conclusion: US Government is taking all kind of actions to kick start the economy. But I fail to understand why they try to mask some of the underlying problems. Sweeping under the carpet will complicate the situation any day and retail investors have to be careful about the stock market movements. In my view, nothing has changed and still there are lots of troubles to be answered. Many small investors feel that they have already missed the bus but I think they will get another chance soon as we have couple of triggers namely Q4 quarterly results and Elections to play spoilsport.


I request the readers to participate in the Sensex 2009 Target poll below.


Stockanalysisonline.com

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Disclaimer

This is a blog about stock market investments, investment strategies, and related topics. Any statement made in this blog is merely an expression of concerned authors opinion, and in no case should it be interpreted as an investment advice to buy stocks, sell stocks, or for that matter advice for any other issues be it money related or not. By using this blog you agree to (i) not take any investment decision, or any other important decisions based on any information, opinion, suggestion or experience mentioned or presented in this blog (ii) verify any information mentioned here, independently from your own reliable sources (for e.g. a registered investment advisor) and thereby check for possible inaccuracies. This blog is to create investment wisdom among general population and the authors are not responsible for
any decisions that you make based on the information provided here.
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