Thursday, December 16, 2010

Does financial literacy make you wealthy?

Not always. There are factors beyond just financial literacy. Let me explain.

There was a recent report of a study done at University of Pennsylvania that shows that there is a big downside in getting financially intelligent – as per this study, “financial intelligence increases the confidence levels of the investor and it leads to him making worse investing decisions.” In a 2005 survey, 65% Americans believed they were 'very' or 'highly' knowledgeable about personal finance, although they performed abysmally on objective questions about the subject.

I see the same attitude in India as well – most people think that they are financially literate. They confuse between savings and investment – they take investment decisions based on gut feel, optimism and unconfirmed data. They take risks that they are not aware of. With Indian economy growing at 8% for the past 10 years, these  people have had some successful investments – they attribute these successes to their financial intelligence – not knowing that when the times are good, you do not need too much expertise to make money. Warren Buffet opines that you do not need above average intelligence to be a successful investor – however one needs the right temperament – to control the urges that get people into trouble.  A good investor offcourse has financial intelligence – but beyond that, he has the right temperament to wait patiently for the right opportunity and not take undue risks.

As I said in my last blog (and this was popular with my MBA students) – “In the search for good investment opportunities, we must adopt the same attitude one might find appropriate looking for a spouse - it pays to be active, interested and open minded - but it does not pay to be in a hurry.”

Tuesday, December 14, 2010

When the student is ready, the teacher will appear

The content given here was was part of the last class that we had – where in I shared my views that Wealth is not really something physical – it is a way of life - a way of thinking – if you can understand this and then work towards thinking and operating the way the wealthy operate – in time, you will also become wealthy - as wealth will come to you.
People who have wealth use their time to create three things –
1.       A  network of acquaintances
2.       Financial fitness; and
3.       Clarity of their long term goals
As you can see, these three things can be created without having any wealth to start with. Hence anyone of us can become wealthy over time by following these three things – constantly build a network of acquaintances whom you can help grow, prosper; build a mindset wherein over time you end up collecting assets ( anything that increases you cash inflow) and not liabilities (anything that increases you cash outflow); and getting clarity through self education and introspection on your long term goals in each of the role that you play daily ( e.g. role of student, friend, classmate, son/ daughter, brother/ sister etc). As we get better and better in these three areas – we will see wealth coming to us.
Similarly, if one was wealthy and suddenly loses all their wealth due to reasons beyond his/her control, they would bounce back in life and become wealthy again as they still would have their acquaintances, financial fitness and goals.
Over time, I have collected quite a few quotes on wealth management that I shared with the class – I hope that you too enjoy reading these – please read it slowly and think about the message embedded in each quote:
1.       You can’t make a good deal with a bad person.
2.       It is easier to stay out of trouble than to get out of trouble –Warren Buffet
3.       It takes twenty years to build a reputation – and five minutes to lose it.
If you think about that – you will do things differently.
4.       Someone is sitting in the shade today because someone planted a tree a long time ago.
5.       You only have to do a very few things right in your life so long as you do not do too many things wrong.
6.       If you let yourself to be undisciplined on the small things, you will probably be undisciplined on the large things as well.
7.       In the search for good investment opportunities, we must adopt the same attitude one might find appropriate looking for a spouse - it pays to be active, interested and open minded - but it does not pay to be in a hurry.
8.       The most important thing to do if you find yourself in a hole is to stop digging.
9.       If at first you do succeed - quit trying.
10.   What we learn from history is that people do not learn from history.
11.   Saving is not investing
12.   Your work is to discover your work and then with all your heart to give yourself to it
13.   Wealth is far more about focus than talent.
14.   If it feels like hard work, you are already doing the wrong thing.
15.   The rich buy assets. The poor only have expenses. The middle class buys liabilities they think are assets –Robert Kiyosaki
16.   It is what you do with your money after you earn it that makes you rich or poor
17.   Success is not in what you have, but who you are
18.   Money won’t make you happy… but everybody wants to find out for themselves –Zig Ziglar

I have finished this course with this session.  However, I believe that wealth management is not a 30 hour course – it is a lifelong lesson and one needs to learn all the time –hence I intend to add to this blog regularly.

Thursday, November 25, 2010

Real Estate investment in India

Currently we have about 300 million people residing in Urban India – appx 30% of our population – with increasing urbanisation, we will be having close to 550 - 600 million people in urban India by 2035 -  This massive wave of urbanisation in India means that our cities will grow to almost double the size in the next 25 years – we can see this happening all around us – if we compare a 1985 vintage map of any city in India  -we would realise that the city has truly expanded to almost double the size – the same thing will repeat –at a larger scale between 2010 and 2025.
Where is the opportunity hidden in this information – if you look at a 20 year horizon, invest in a plot of land (any size that you can afford) in an upcoming gated development that is 10-15 kms away from the current city limits –in 20-25 years, this locality would be part of the city and the value would have grown tremendously. Anyone who did this in 1985 knows the value of this smart investment and the same opportunity exists even today. The key issue here is that the land must be safe from encroachment for this period of 25 years - hence it must be a gated or walled development.
Real estate investment in India offers tremendous potential to get a 20% plus returns – it is quite difficult to make a mistake if one knows the basic rules of investing in real estate. Real estate investment is like a fixed deposit with near zero risk giving atleast 15% returns per annum. Once you have about 10-15 lacs worth of assets created – make your first real estate investment –- leverage your position by putting 20% of the investment from your savings and remaining 80% through a loan. Leveraging is a commonly used technique in this area as the investments are in large chunks and the appreciation of property is normally more (15-20%) than the interest costs (10%) of the loan. My class presentation is available for you in and has some scenarios described on how leveraging works.
There are broadly five ways of investing in real estate:
·         Residential properties – flats and residences with land
·         Commercial properties – offices, shops, godowns etc
·         Urban Land – commercial, industrial, residential
·         Rural land – agricultural
·         Real Estate Investment Trusts ( REIT)
I consider the other way of investment in real estate sector through Real estate equities as not truly a real estate investment as this does not represent the true real estate risk/ reward scenario in India.
Let me elaborate on these five ways on investing:
Residential properties – contrary to popular opinion, this must ideally your second investment  -not the first investment – residential properties give you capital appreciation (10-25% pa)  and rental cash flow (2-5% pa) – the overall returns are 15% to 30% pa and I believe this will go on for at least another two decades in India due to urbanisation and economic growth. The land appreciates at a higher rate than building and hence the residences with land would show a higher appreciation than flats. However, due to good common amenities (like security and club house), the flats give a higher rental yield than residences with land. A good location, a good builder /architect, good landscaping, good common amenities will give higher ROI and hence one has to select properties based on these parameters. The minimum investment required (including loan) would be around Rs 50 lacs.
Commercial properties: This must be ideally your first investment – I have not seen too many people do this as their first investment – but those who have done it are more financially savvy. The reason for this is that, the commercial properties give the same capital appreciation of 10-25% pa as residential properties – however, they give a rental yield of 7-10% pa and that is double the rental yield of residential properties. Also the minimum investment required here is around Rs. 15-20 lacs as compared to Rs 50 lacs in residential properties. Early in life, when one wants to increase the cash flows from investment, higher rental helps – hence when compared to residential properties, we must look at investments in commercial properties early in life. Once we have become financially independent ( i.e. our cash flows from investments are more than our expenses), then we can look at residential and other investments. Go to any broker, look at the Sunday edition of Times of india and you would be surprised to see the kind of options that commercial real estate offers – however, surely do a legal check and also take advice from broker on the rental yields before investing.
Urban land – Once you have become financially independent, you must invest in urban land – land gives higher capital appreciation than buildings – my experience has been at least 20% pa – normally higher if the location is good. So after having a few rental yielding properties and after becoming financially independent – focus on urban land and keep a minimum of 5 year window for these investments – you will more than double your money.
Agricultural land – Investments in agricultural lands that are 10-15 kms from some urban area will give good appreciation over 15-20 years – however, lands that are truly rural and far away from urban areas – may not give good appreciation or rental. If you are investing in lands like these – do not expect a great appreciation unless there is some development in that area in the future.
REIT  - REIT is a good way to gain from real estate appreciation without getting into the legal and asset maintenance issues – REIT’s came in India as an investment structure in the last one decade and India REIT is the pioneer in our country. The company offering REIT takes commitments of Rs 25 lacs from investors over 2-3 years and they invest this money through well known real estate developers  in residential /commercial properties being built by them – as these properties get ready and are sold, the profits from this sale are given back to the investors  - this takes about 7-8 years to materialise – there was another flavour of this REIT before recession where the REIT company used to buy existing commercial spaces and the rental yields was given as quarterly yield, and after 5-7 years, they sold the commercial assets and returned the principle and profits from the investments. If you have 25 lacs to invest and do not want the hassles of legal work, property maintenance work, but still want the gains that one gets in real estate – REIT is highly recommended. These are closed funds and hence you will have to keep an eye for when these offers are available – ask your wealth manager and he will tell you when one comes up.
There are a few very logical, practical and doable tricks for real estate investment that I have shared in my class – these are in the ppt for you to see in slideshare.
As MBA’s starting your career, you must build your asset value of about 15 lacs in the first 3-5 years of work through equity route and then before marriage, invest in a property that yields rental plus capital appreciation – a commercial property is what I would recommend. Over the first 15 years of your career, you must own rental yielding properties worth 150 lacs  (in today’s value) – if you can do that, you will be financially independent by then– after that based on your savings, invest in land to get good appreciation.
But before all that, advice your parents to invest in an upcoming gated development that is 10-15 kms away from the current city limits in your city.

Tuesday, November 9, 2010

Insurance as an investment vehicle

After a break of one month, I would like to restart and share details on Insurance products available in India and what products you must use in your quest to create wealth. My presentation of this session can be downloaded from
Insurance is designed to protect the financial well-being of an individual, company or other entity in the case of unexpected loss. Agreeing to the terms of an insurance policy creates a contract between the insured and the insurer. In exchange for payments from the insured (called premiums), the insurer agrees to pay the policy holder a sum of money upon the occurrence of a specific event.
In other words, Insurance is a promise made by the insurance company to pay a certain sum of money at some future date or on the happening of an unfortunate event.
The concept behind insurance is that a group of people exposed to similar risk come together and make contributions towards formation of a pool of funds. In case a person actually suffers a loss on account of such risk, he is compensated out of the same pool of funds. Contribution to the pool is made by a group of people sharing common risks and collected by the insurance companies in the form of premiums.
There are three broad categories of insurance –
1.       Non life or General insurance - that insures against the loss of assets like house, car, factory etc.
2.       Health insurance – that insures against loss of health.
3.       Life insurance – that insures against the loss of life.
As we discuss wealth management, the only area where insurance is relevant is
·         When we are insuring the assets that we have created; or
·         When we are insuring our family against loss of life or health; or
·         When we have a liability like a home loan or a car loan, then we need to insure against the risk of loss of life of the primary wage earner for the amount of loan taken.
·         Another relevant area where risk mitigation is necessary is when one lives longer than normal and needs to fund the old age.
However, no discussion in wealth management goes without discussing insurance as a wealth management tool – this is because there are various offerings by insurance companies that mix this risk mitigation strategy with investment strategy. As customers, we are not able to differentiate between the cost of risk mitigation and the investment returns that these insurance companies are committing. So let me describe the basic four types of insurance and share my views:
1.       Term insurance –in this type of policy, the policy holder pays a premium and get insured against death for a particular term – in case of the unfortunate event of his/her demise during that term, the insurance company would pay to his/her nominee the amount insured. If there is no demise, the policy holder does not get any returns. The annual premium for someone aged 25 years for a sum assured of Rs 100 lacs for 20 years term is only around Rs 10,000. This means, if you take this policy, you will need to pay Rs 10,000 per year for the next 20 years and during this period, if you lose your life, your nominee would get Rs 100 lacs. This is a pure risk mitigation policy that I recommend that each one of you take –the earlier the better.
2.       Whole life insurance – this policy runs as long as the policy holder is alive. The policy holder pays a premium every year for a period of 15 to 20 years and that will assure the nominee the insured amount plus bonuses on the death of the policy holder. In some cases, if the policy holder lives up to 85th year, then the company would pay the insured amount plus bonus to the policy holder itself.  The premiums here are high and part of the premium is invested and another part goes towards risk mitigation from death. For example a well known insurance company offers for 25 year olds, a premium of 2.66 lacs per year to be paid for 20 years for a sum assured of Rs 100 lacs – which will be paid along with bonuses either on death of the policy holder or on his/her 85th birthday. As you can see, 60 years is a long time and the returns are not good enough for a payment of 2.66 lacs per year for 20 years. Hence such policies are not recommended - instead take a pure term policy (which costs Rs 10000 per annum) and invest the remaining 2.56 lacs yourself – the returns will be better.
3.       Endowment policies – These policies are designed to provide a benefit to the policy holder at a stage of life when a lumpsum of money is required – like marriage of daughter or college education of kids or retirement time. Plus there is a benefit in case of death. For example a well known insurance company offers for 25 year olds, for a premium of Rs. 10.94 lacs per year, to be paid for 5 years, a sum assured of Rs 100 lacs for 30 years – this 100 lacs will be paid along with bonuses either on death of the policy holder or on his/her 55th birthday (pre-retirement amount). As you can see, the policy holder is paying almost 55 lacs for the first 5 years and gets a term policy that he can get by paying 10,000 per year plus Rs 100 lacs plus bonuses after 30 years – it does not take too long to understand that this too is not an optimum investment strategy and we could do better by taking a term insurance and then investing the remaining amount directly. The endowment policies come in various forms and all of them have an investment /returns angle and an added death benefit. Unit linked insurance plans go further where they declare the value of units just like NAV’s in Mutual funds. Also in these policies, there are quite a few charges that the insurance companies charge – premium allocation charge, mortality charge, fund management fee, administration charge, surrender charge and fund switching charge. These charges are much more than what one would be charged by fund managers for managing your funds in wealth management companies. Hence it is far better to manage your own funds than use these endowment policies.
4.       Pension plans or Annuities – these policies cover the risk of living too long (unlike the risk of dying too early) – here you pay one single lumpsum or pay a premium for a few years now and in return get an assured pension after a particular age (normally retirement age). For example, a well known insurance company offers for people in their 50th year, for a one time premium of 1000, a pension of Rs 42.79 per year for as long as he/she lives. As you can see, it comes to an ROI of 4.27%. We can do better than this simply by investing in a bank FD. Hence this too is not recommended.
As you can see, Insurance is a good wealth creation vehicle – not for you – but for the insurance company– hence it is better just to take pure term insurance and manage your investments directly or through a wealth manager.

Saturday, October 9, 2010

Short note on Fixed Deposits

Fixed Deposits in India give returns of about 8-11% per annum. Inflation in India is around 8-9% and the interest from FD’s is taxable – hence FD’s cannot be used as a tool for wealth creation. However, FD is a good investment option for wealth preservation. Hence at the stage where you are, the wealth creation stage, FD’s are not the best option to invest.  And for people at the wealth preservation stage – the retirees for example, FD is a good option.
Having said that let me share with you few salient details on FD:
  1. Traditionally, fixed deposits, as the name suggests, earned interest at fixed rates. However, recently this has changed. Now every bank has to declare a base rate every quarter (based on their cost of capital and other economic factors) – and the interest on all the existing FD’s would be linked to this base rate. Hence the FD is now technically a Floating rate deposit.
  2. Each depositor in a bank is insured up to a maximum of Rs.1,00,000 for both principal and interest amount held by him. Hence there is safety till Rs 100,000 in the FD’s if the bank folds up.
  3. Investments in fixed deposits up to a maximum of Rs.100,000 for 5 years are eligible for tax deductions under section 80 C of income tax act.
  4. Fixed Deposit tenures can be as low as 7 days and the minimum amount can be as low as Rs 100.
  5. For FD’s more than 15 lacs, the interest is decided daily by the banks.
  6. While investing in FD’s one must look at the charges that will be levied in case of premature withdrawal.
  7. Also we must appoint a nominee as a best practice when we invest in an FD.
  8. Corporate deposits compete with bank FD’s and they tend to give a slightly higher rate of interest as there is a slightly higher risk in this case.
  9. Then there are Mutual funds that invest in Debt instruments – these do not commit returns unlike FD’s but they are more liquid than FD’s

Thursday, October 7, 2010

Investing in Equities - part 3

Having answered a YES in the 11 questions listed in my last blog – the company in question (CRISIL) is in our shortlist for investment – it means that the company has
  • a long term sustainable competitive advantage;
  • has good future good cash generation potential; and
  • is in the hands of a good management that has managed it well for the past 10 years.
Now, we come to the final 3 questions – these questions will help us decide at what price we must invest in the stocks of this company. Remember that a good company with all the advantages listed above is not a good investment until the share price is right. The next three questions help us decide what the right share price is. There is a bit of maths here – but I have tried to make it as simple as possible.
Q12 - What is the initial rate of return (IRR) and relative value to a Govt bond?
Government bonds are considered to be zero risk investments - in India, the 10 year Govt bond has an interest rate of 8% as of Oct 2010.  This question focuses on the comparison between the returns on the chosen share with these 8% Govt. Bonds.
The basic understanding is that as a share holder, your annual return per share is the Earnings per share (EPS data is available in the P&L statement).  We need to compare the returns based on the the EPS data and the current market price of share, with the returns from Govt bond (8%). Further, as the EPS changes every year, we need to look at the 10 year CAGR of the EPS and also account for this in our analysis.
For example in CRISIL, the current EPS is Rs. 208.08 - which means that CRISIL has earned Rs. 208.08  for each share in the period Jan 2009 to Dec 2009.  With the current share price of CRISIL at Rs.6130, and EPS of Rs. 208.08 , CRISIL share is giving a 3.4% return as compared to a Govt bond’s 8% return. If we had to earn the same amount (Rs 208.48) via investment in 8% Govt Bonds – we would need to invest only 208.08 / 0.08 = Rs 2606. Based on this logic, it does seem that CRISIL share price is pretty high.
However, this analysis is not complete as it must also take into account the fact the EPS of CRISIL is growing year on year and hence the returns on CRISIL will increase year on year. The CAGR of EPS of CRISIL is 27.8% (please refer to the calculations in Even though CRISIL share is currently giving us a return of 3.4% as compared to a Govt bond return of 8% - this return of 3.4% is growing at a CAGR of 27.8% yoy.  In four years time, the current returns of 3.4% would surpass 8% and hence after 4 years, the CRISIL investment made today would have a better IRR than a Govt Bond.
Hence the answer to this question is that CRISIL’s share price is on the higher side as of now   - however, if we buy it at the current price and keep it for 4 years, the returns will match that of 8% Govt bonds.

Q13 - What is the projected share value and return on investment using historical earnings growth rate
Q14 -What is the projected share value and return on investment using sustainable growth rate
Q13 and Q14 give us ways of forecasting the share price of the company 10 years from now. They follow two different approaches and there would be two different share prices forecasted. Being conservative investors that we are, we would consider the lower of the two prices. The common theme in these two approaches are:
  • both approaches try to forecast the EPS into the future;  
  • we assume that the average Price to Earnings ratio (PE Ratio) of the share for the last 10 years would be same as the PE ratio for the next 10 years;
  • the future price of the share in 2020 = future EPS in 2020 * average PE ratio
  • we also assume that the average dividend payout ratio ( calculated as the ratio of dividend paid out per share to the earnings per share) for the past 10 years can be taken as a average dividend payout ratio for the next 10 years.
We calculate the following as we forecast the future share price value:
  • The CAGR of EPS for the past ten years - the calculations for CRISIL is shown in the excel sheet and it is 27.8%
  • The average Returns on Equity (ROE) for the past ten years – the calculations for CRISIL is shown in the excel sheet and it is 23%
  • The average Dividend Payout ratio for the past 10 years - the calculations for CRISIL is shown in the excel sheet and it is 33.95%
  • The average PE ratio for the past 10 years – here we need to get the High and Low share price for the past 10 years and use this data along with the EPS for the past 10 years to calculate the average High PE and average Low PE ratios. The overall average of the High and Low PE ratios is the average PE ratio - the calculations for CRISIL is shown in the excel sheet and it is 20.545.
Answer to Q13 – The Historical earnings Growth rate:
Please see the excel sheet as we do this forecasting of future share price.
We take the EPS for the current year (Rs. 208.08) and the average CAGR of EPS (27.8%) and calculate the EPS for the next 10 years using the formula:
EPS for 2011 = EPS for 2010 * average CAGR of EPS.
We also calculate the Dividends that will be paid out each year in the future based on the formula:
Dividend for 2011 = EPS for 2011 * average Dividend payout ratio
By this method we can calculate the EPS for the year 2020 (Rs 2418.46) and with an average PE ratio of 20.545, the future price of CRISIL share in 2020 is Rs 2418.46 * 20.545 = Rs 48687.26.
To this we must add the sum of dividends paid for the period 2010 to 2020 (Rs 3520.43) to calculate the total gains = Rs.53207.69.  Assuming the current price of 6132 – the CAGR of this investment over the next 10 years comes to 24.37% - which is remarkably good.
Answer to Q14 – The Sustainable Growth rate:
Please see the excel sheet as we do this forecasting of future share price using this model.
Here we take the Book value of the share in 2009 and calculate the EPS of the share for 2010 using the formula:
EPS for 2010 = Book value of the share in 2009 * average ROE (which has been calculated as 23%)
We further calculate the Dividend payout for each year from the EPS and the dividend payout ratio (as done for the last question) and based on this we calculate the retained earnings (Retained earnings = EPS –Dividend paid out).
We then calculate the Book value for the next year using the formula:
Book value for 2011 = Book Value for 2010 + Retained earnings for 2010.
This model is used to predict the EPS for 2020 (Rs 539.8) and the total dividends paid out for the period 2010 -2020 (Rs 1096.34). With an average PE ratio of 20.545, the future price of CRISIL share in 2020 is Rs 539.8 * 20.545 = Rs 11090.21.
To this we must add the sum of dividends paid for the period 2010 to 2020 to calculate the total gains = Rs.12186.55.  Assuming the current price of 6132 – the CAGR of this investment over the next 10 years comes to 7.1% - which is not all that good especially when we know that Govt bonds give 8% returns per annum.
As conservative investors, we will take the lower of the two figures that we get from the two models – hence the return from the second model (Sustainable growth rate model) is what we will take. For us to get a CAGR of at least 12%, the current price must be Rs.3923.8.
Hence we would be happy to invest in CRISIL share at a price of around Rs 4000 but not at the current price of Rs 6132.
CRISIL was priced around Rs. 250 in 2003 and today it is Rs. 6132 – it has grown by 24 times in 7 years. In 2003, when we had done the same calculation, we had predicted that the share price would go to Rs 1350 by 2010 – time has shown that our estimate was very conservative. Hence the call is whether we should look at investing in this stock at the current levels or wait for a level of Rs 4000 which may never happen. My approach would be to wait and if it does not come to this level – we should still be patient.

Thursday, September 30, 2010

Investing in Equities -part 2

I will share with 14 questions that we need to ask before we invest in any share – these questions describe the way Warren Buffet analyses companies – these questions are not mine – it is from a very popular book called Buffetology by Mary Buffet – she had access to Buffett’s thought process as she was his daughter in law for 12 years and she has described his philosophy of investing in the book - I have tried to follow it since 2003 and it has given me good results. 
I will also take the example of CRISIL to discuss the issues raised in these questions. As a starting point, I have uploaded the Balance sheet and the P&L statement of Crisil of the past 10 years along with some calulations – it is available in . Before you go ahead with my questions, it is suggested that you look at this data of Crisil. The presentation made in this session is also available for download in
So here are questions that we need to ask:
Q1 – Does the company have an identifiable durable competitive advantage?
The company must have product /service offerings that is somehow unique and difficult to reproduce – strong brands, entry barriers (like telecom licensing in India) or technology leadership (like patents in Pharma industry) are good examples of identifiable durable competitive advantage. Normally companies in this category would have strong upward trend in earnings ( Crisil’s Net profits have consistently increased over the last 10 years) – these companies normally are cash rich and do not need excessive debt ( Crisil has zero debts for the past 10 years) and a high return on shareholder’s equity (Crisil’s average ROE for the past 10 years is 23%).
The answer for CRISL is a YES – it is a well respected brand, a market leader and a pioneer in this industry in India and it’s financials also show that it has a durable competitive advantage
Q2 – Do you understand how the company’s business model works?
Before investing in even a single stock – you will need to figure out the industry dynamics – the key areas where the target company is strong vis a vis it’s competitors –and what is required for the company to survive in the next two decades.
Crisil’s business is based on it’s internal processes and templates that has been perfected over the years, on it’s ability to attract and retain talent and it’s good track record.  So the answer to this question is also YES.
Q3 -What is the chance that the product /service/business model would be obsolete in the next 20 years?
Will there be a market for this product /service 20 years from now and will the company be able to manage the changes that can happen in technology, consumer preferences etc.
Crisil’s product /service offerings will be required after 20 years as well – rating is an expert’s job and one cannot automate it fully and there will always be investment opportunities that need to be rated. So the answer to this question is also YES.
Q4 - Does the company allocate capital exclusively in the realm of expertise?
Does the company sticks to what is knows best and does not invests in completely new businesses. What has been the track record in this area in the last 10 years.
Crisil has not had any unrelated diversifications in the past 10 years and it is allocating capital to it’s realms of expertise. Here too we will give a Yes answer
Q5 - What has been the company’s EPS history and growth rate?
Earnings per share is a very good starting point to see the financial performance. The company that we will short list for investing should have a consistently good record of growth of EPS over the past 10 years – erratic EPS growths and dips will disqualify the company from our shortlist.
Crisil has had a good growth of EPS from Rs 20.83 per share in 2000 to Rs 208 per share in 2009. There has been two years where there were dips in the EPS  - one of them 2001 is not a minor dip  - but we also know that in 2001 there was a global slowdown post the Ecommerce bust in the US markets . So the answer to this question is also YES.
Q6 - Is the company consistently earning high Return on equity?
Return on Equity = Reported Net profit / Net worth
The company must show a consistently high ROE over the past ten years – In India, an average ROE above 20% would qualify as a high ROE.
Crisil’s average ROE for the past 10 years is 23% and hence the answer to this question is also YES.
Q7 - Is the company consistently earning high Return on total capital employed (ROCE) ?
Return on total capital employed = Reported Net profit / (Net worth + secured loans+ unsecured loans)
Like in the last question, the company must show a consistently high ROE over the past ten years – we need to compare the ROCE with it’s peers in the industry.
Crisil has no debts and hence it’s average ROCE for the past 10 years is a very high 23% and hence the answer to this question is also YES.
Q8 - Is the company conservatively financed?
This question again looks at the debt coverage for the company – companies that we want to shortlist and invest must have strong cash flows and hence would be cash rich and would not have requirements for large long term debts.
Crisil has no debts and hence the answer to this question is also YES.
Q9 - Has the company been buying back its shares?
Cash rich companies have the option of reinvesting their earnings within the company by buying back it’s shares – if there is a history of share buyback, then there is a good chance that the company is financially strong.
Crisil does not have a history of buyback – in fact it has increased it’s number of shares from 62 lac shares to 72.25 lac shares in the period 2000 to 2010. However, we will progress forward with our shortlisting despite a NO as an answer.
Q10 - Is the company free to adjust prices to inflation?
Companies with sustainable competitive advantage would be able to increase the prices to inflation without the risk of losing significant volume of sale –this means that the profitability of the company will not be eroded overtime by inflation.
Crisil, we believe, can increase it’s prices and hence the answer to this question is also YES.
 Q11 – The company should not need to constantly reinvest in capital?
Retained earnings must first go toward maintaining current operations at competitive levels, so the lower the amount needed to maintain current operations, the better.
Crisil does not really need too much of reinvestment to keep it’s operation running. Hence the answer is again a Yes.
Till now Crisil has passed all the filters – just take any company of your choice and try answering these questions – you will be surprised with the discovery that very well known companies would not pass these filters. Only after the company passes these 11 questions with a Yes answer, does it qualify for our investment.  Once it is qualified, then we need to look at whether the current price in the market is right to enter or not. That will be covered in the last three questions.
 I would share the last three questions in a day or two – through those questions, we will qualify the current share price as low or high and also forecast the future share price ten years from now - that will ultimately decide at what price the share is a good buy.

Monday, September 27, 2010

Investing in Equities -part 1

In this session, I would like to share with you the basic strategies that Warren Buffet has followed over the past five decades.
Warren started out early in life - as a school kid, he made money selling lemonades and having a news paper route. At the age of 14, with his earnings, he bought 40 acres of land and rented it out. In college, he studied Value investing under Benjamin Graham –the father of value investing. Value investing denotes an approach where investors pick up stocks at rock bottom prices.  He went into stock broking after college and by the age of thirty, he was a millionaire. He started Buffet associates in 1962 - over time bought a dying textile mill called Berkshire Hathaway. Using the cash generated from the mill, he slowly invested in other companies – overtime these investments overshadowed the textile operation and in 1985, he shut down the textile business altogether. His investments have given a CAGR of 20% plus between 1964 and 2009 and today, he is the third richest person in the 2010 Forbes list with a net worth of USD 47 Billion.
The basic investment philosophy of Warren can be described in the following Buffet quotes:
·         Rule No.1: Never lose money.   Rule No.2: Never forget rule No.1.

·         You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.

·         All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies.

·         If a business does well, the stock eventually follows.

·         The best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.

·         Time is the friend of the wonderful company, the enemy of the mediocre.

·         Never invest in a business you cannot understand.

·         Risk comes from not knowing what you're doing.

·         Wide diversification is only required when investors do not understand what they are doing.

·         Diversification may preserve wealth, but concentration builds wealth.

·         What we learn from history is that people don't learn from history.

Warren believes that any equity investor should view the company in the same way as any business person buying up the whole company –focussing on its cash generating potential in the future   – overtime the company that has a superior cash generating potential would give a good value appreciation of the stock.
Warren identifies excellent businesses and then sets out to acquire the shares of the business if the price is right.  Once invested, he holds the investment for long term until the business loses its attractiveness or until a more attractive alternative investment becomes available.
In this session, I describe 14 questions that one must ask before investing in any company. I also take an example of CRISIL to explain these questions – at the end of these 14 questions, we will arrive at two ways of projecting the stock price of CRISIL in 2020 – and this would then give us the 10 year CAGR if you invested in CRISIL today – I also share results of the same calculation on CRISIL done in 2003 and see what the results looked like today.
For details of these 14 questions, you will need to wait for a few more days. Patience is one of the halmark of good investors :-)