Stock Market Investing

Growth

Stocks of quality companies that have been recording above industry average growth and are expected to continue doing so in the future are called growth stocks. Because of the company’s future growth prospect, market often assigns high value to such stocks resulting in a high PE ratio

Growth investors are primarily concerned with fast growing young companies which operate in rapidly growing industry. Investors who buy growth stocks focus on earning investment returns almost exclusively through capital appreciation resulting from increasing stock price. Growth companies usually retain cash for reinvestment purpose and do not pay dividends

Examples of growth investing strategy available on smallcase platform are:

Growth at a Fair Price

As explained above, market often assigns high valuation to growth stocks. But everything has a fair price and irrespective of the quality of the product/stock, one should never overpay. This smallcase is a collection of companies experiencing earnings growth, witnessing margin improvement and increasing return on capital, and are still available at justifiable valuations

There is also a low-cost version of this smallcase to buy and invest in regularly

Coffee Can Portfolio

This smallcase selects companies whose revenue has grown by at least 10% every year for each of the last 10 years and ROCE was at least 15% for each of the last 10 years. The strategy helps you rise above the market volatility and noise by going for a long time horizon of 10 years. Additionally, it also helps in saving transaction cost, as there is no re-balancing done once bought

Value

Stocks of companies which trade at a lower price relative to its fundamentals are termed value stocks. Mature companies with stable cash flows but moderate growth rates usually trade at low levels. However sometimes negative perception about the industry or company due to multitude of reasons might also result in stock price of the company taking a beating resulting in cheap valuation

Value investors seek out stocks with strong fundamentals – high operating and net income margin, positive operating cash flow, low debt to equity ratio, high return on equity etc – that are trading at a bargain. The investor hopes to gain via capital appreciation when the market identifies the true potential of the stock and price increases

Examples of value investing strategy available on smallcase platform are:

Bargain Buys

This smallcase is designed for a layman investor and consists of stocks which boast of strong financial position, manageable debt and stable earnings. It is based on Benjamin Graham’s investment philosophy. Also Warren Buffett’s mentor, Graham is widely known as the father of value investing. His belief – that inexperienced equity investors should invest into conservatively financed companies with long history of profitable operations – is reflected in this smallcase

Value and Momentum

This smallcase includes stocks which are undervalued compared to ther industry peers, however have been attracting attention off late as evidenced by their recent stock price movements. These stocks have also earned higher than expected profits during the latest reported period

Sustainable Earnings

This smallcase consists of companies which have been recording higher sales and earnings, increasing their cash flows but are trading at lower levels compared to their peers

Dividend

Dividend is a portion of company’s net profit that is paid out to shareholders. Dividends are usually issued as cash payments. Financially secure mature companies usually tend to payout dividends on a regular basis providing investors with a stable source of income

A simple dividend investing strategy involves investing in companies that have a consistent history of paying out dividends. You can buy the Dividend Aristocrats smallcase to execute this strategy

This smallcase consists of companies which have increased their dividend payout consecutively, for the last 10 years.

A slightly intuitive strategy involves seeking out companies that have a consistent history of dividend payout as well as high dividend yield. A high dividend yield / increasing dividend yield can be due to either higher dividend payout or falling price, with the former scenario preferable. A company whose dividend yield is consistently above industry average is a good investment bet

Tata Chemicals, which manufactures soda ash and sodium bicarbonate for diverse end user industries, has a consistent history of dividend payout over the last decade with the average yield during this period being 3.4%. This company is part of the Dividend Stars smallcase.

The smallcase consists of companies who have maintained an average dividend yield of at least 3% over the previous 10 year period without any slash in dividend during that period

A buy is a sell

Let’s discuss this concept using an example. Suppose you want to measure the number of transactions taking place during a working day in the nearby fruit market. The market opens at 9.30 AM every day and closes by 5 PM. Note that the number of transactions are always measured for a particular period, say 1 hour or 15 minutes and not at any particular moment like 10.12 AM. Another important point is that number of transactions is not the sum of buy and sell activities, but the total number of buy or sell activities which is equal to the total number of sell or buy activities. This is because one cannot buy unless someone else is willing to sell. So if at 10.45 AM, one were to say 200 transactions have taken place, it means that since 9.30 AM 200 people have bought and sold fruits.

Now let’s replace fruits with stocks and transactions with volume in the above example. Volume of a stock is the total number of transactions taking place in a stock during a particular time period. If one were to say that volume of a stock at 10.45 AM is 50,000, it means that since the open of the market at 9.20 AM a particular stock has been bought and sold 50,000 times. Just like price, volume is an important indicator to understand whether money is moving into or away from a particular stock. In the case of fruit market, if more transactions are taking place in mangoes compared to other fruits, it can be interpreted that more people want to buy and sell mangoes compared to other fruits. This increase in interest could be because of two different reasons. One reason might be that more people are buying mangoes and hence demand is increasing causing price to increase. Alternatively suppliers might have stocked up mangoes in huge quantities which they want to sell off, so they are enticing buyers by decreasing prices. Similarly, sudden increase in volume of a stock could be because of two reasons. Increased demand for the stock might have pushed up activity in the counter leading to price increase. Alternatively, current shareholders might be selling the stock in droves, increasing activity in the counter thereby lowering prices.

Volume also indicates liquidity available for a stock. Liquidity refers to the ease with which a stock can be bought or sold in the market without affecting its price. To understand this better let’s revisit our example of fruits market. Suppose you have a stock of 50,000 apples that have to be sold. Current market price of a single apple is Rs.25 and 40,000 apples were sold in the market the previous day. If you decide to sell all 50,000 apples today, supply of apples in the market will drastically increase compared to the previous day’s level and hence price will probably drop down below Rs.25. But suppose, previous day was holiday and you believe apple sales suffered because of the same. The best alternative then is to calculate the average number of transactions over the past one month to smoothen the effect of abnormally high or low transaction numbers. Suppose average number of transactions over the past one month is 20,00,000 apples a day.  Now you can be sure that attempting to sell 50,000 apples a day will not affect price as market offers sufficient liquidity for apples. The same analogy applies in case of buying and selling stocks as well. Whenever an investor wants to buy/sell stocks in huge lots, it is prudent to check the average volume over the past 1 month / 3 months to make sure that price impact is limited.

We discussed trends in our previous article. If volume is increasing in a bull trend, it means that momentum is increasing and more and more people are joining the trend. Suppose volumes are decreasing in a bull trend we can assume the the stock is losing momentum and the trend might reverse soon. The same logic applies in case of other trends as well.

Trend

Your best friend

You might have seen technical analysts analyzing charts on various business news channels and telling that a particular stock is in uptrend/downtrend. When we say a stock is in uptrend it means that we expect stock price to move upwards in near future. Similarly, when we say a stock is in downtrend it means we expect stock price to move downwards in near future. You would have noticed that prices rarely move in a straight line. Even if the stock price has moved up, over the last year, there will be days or months when it would have moved down, compared to the previous close. So how do we define a trend? Technical Analysis says that if the stock price is moving up and making higher highs and higher lows, it is in uptrend. Let’s understand this through an example.

Suppose you decide to analyze traffic situation at a nearby signal. You know that signal becomes green in every 5 mins and remains open for the next 5 mins. At 6pm you observe that there are 100 cars waiting at the signal which just turned red. The signal will become green at 6:05 pm and will again become red at 6:10 pm. You observe that in every 5 mins 30 cars arrive at the signal and add up to the queue. In the 5 mins, when signal is open, 50 cars pass by. Let’s note down your observations at various points of time

At 6:00 PM	Signal just turned red and there are 100 cars waiting
At 6:05 PM	In last 5 mins, 30 cars were added to the queue and now the number of cars waiting at signal is 130. Signal turns green. HIGHER HIGH!
At 6:10 PM	50 cars pass by when the signal was open, but 30 were again added in the last 5 mins. So total cars at the signal are 130+30-50 = 110. HIGHER LOW!
At 6:15 PM	Again 30 cars were added to the queue. Number of cars become 110+30 = 140. Signal becomes green. HIGHER HIGH!
At 6:20 PM	50 cars pass by in last 5 mins when the signal was green, but 30 were again added. Now the number becomes 140+30-50 = 120 HIGHER LOW!

As we can see, no of cars at the signal makes a higher high in every 10 mins starting 6:05 PM. At 6:05 PM it was 130 which became 140 at 6:15 PM. This will become 150 at 6:25 pm, if you keep calculating. This is an example of uptrend. You can see this trend in the first half of the chart below.

At 6:25 pm, we can say that no of cars at the signal are in uptrend and we expect them to increase in near future.

Let’s say you observe that around 7 pm, it starts getting less congested and only 25 cars are added to the queue in every 5 mins, instead of 30 cars. Previously 60 cars were getting added to the queue in every 10 mins and only 50 were moving out, as the signal only opens for 5 mins in a 10 min window. After 7 pm the situation has changed. Now, only 50 cars are getting added in every 10 mins and we know that same number of cars will move out, in 5 mins when the signal is open. So now the traffic has become stagnate. It’s neither increasing nor decreasing, as 25 cars are added in every 5 mins but in next 5 mins, 50 move out. This situation is depicted by the middle part of the chart below.

After 7:30 pm, you observe that only 20 cars are getting added to the queue. Now the pattern will make lower highs and lower lows. We recommend trying this scenario yourself. Traffic situation will improve because we know that only 40 cars are added to the queue in every 10 mins and 50 cars are moving out. We can clearly say that no of cars at the signal are in downtrend and now we expect them to decrease with time.

If we join all the highs, it’s called resistance. If we join all the lows, it’s called support. Keep reading, as we go in details of trend, support and resistance in our next post.

What is a chart?

Making sense of data

Charts/graphs make data analysis and interpretation very easy. Suppose, if we give you last 5 years of daily price data of TATA motors, you cannot conclude anything just by looking at the numbers because of the sheer volume of data. But if we make a graph by plotting this data and then show it to you, you can easily find out what happened to the stock price near last Diwali or which were the periods when it went up/down. Thus, understanding charts become very important for investment analysis.

Generally, we deal with 2-dimentional charts with time on horizontal axis and price/volume/other parameters on vertical axis. To understand what information is presented by every single point on a 2D chart, we can drop a straight line parallel to vertical axis on horizontal axis and a straight line parallel to horizontal axis cutting vertical axis. Suppose, the point at which line cuts horizontal axis is x and the point at which other line cuts vertical axis is Y, then the point represents that the price of the stock was Rs Y on X date. Horizontal axis can have different time units as smallest interval: seconds, minutes, days, weeks etc. In a graph with smallest horizontal unit as seconds, we would be plotting prices at each and every second. When the unit is week, we will have just one price for every week and we would be plotting these prices for different weeks. It could be weekly average price, last traded price or first traded price, depending on the requirement. If I want to plot last year’s price series of a stock, and keep day as the smallest unit for time axis, I need 365 data points to complete my graph. For the same time period, if I keep week as my smallest unit, I will need only 52 data points, as there are only this many weeks in a year.

To make this clear, we have shown three graphs below. All graphs plot 3 months stock price movement for Maruti. First chart uses day as the smallest unit and is constructed by plotting daily prices for 3 months.

The second chart below uses a week as the smallest unit.

We can easily see that first chart shows more information, compared to the second one. We can only see average price for every week in the second chart, and not what happened during the week – whether price initially went up then came down or vice versa. In general, charts with small intervals show more details. Just like horizontal axis’s smallest interval, vertical axis’s smallest interval also matters a lot. In first two graphs, smallest interval for vertical axis is 300. Suppose, instead of 300 it was 3000, then after 3900 the next point would have been 4900 directly. In this case the whole graph will shrink, as shown in the 3^rd chart.

Let’s now learn more about various types of charts.

Technical Analysis

History repeats itself

Technical analysis is all about studying patterns in historical market data, in order to find out recognizable trends to predict future. This means charting historical market data (price & volume) and trying to find out some repetitive patterns, and hoping that it will again be repeated in future. By doing this, a technical analyst is actually studying the market behaviour under various supply and demand scenarios.

“They are a reflection of the trend in the hopes, fears, knowledge, optimism, and greed of market participants. The sum of total of these emotions is expressed in the price level, which is, as Garfield Drew noted, “never what they (i.e. stocks) are worth, but what people think they are worth”

Price of a stock depends on its supply and demand. If more people are interested in buying ITC, compared to the number of people willing to sell ITC, its price will increase. Technical analyst, while looking at historical patterns, is actually studying different supply & demand scenarios and trying to figure out at what price, supply is more than demand and vice versa. Suppose in a particular stock, the analyst is able to locate a pattern of behaviour historically. He concludes that in the future, when the same supply and demand scenarios play out, the stock price will once again behave as it did historically. According to technical analysis, this will happen because people are consistent in making their choices, when exposed to similar situations. So when they are exposed to similar demand and supply situation, they will behave in exactly same fashion as they did last time and as a result, stock will follow the predicted path.

Technical analysis helps you build a good POV (point of view) about the market. By POV we mean it can help you in deciding good entry & exit points, holding period and risk-reward ratios. It is best used for identifying short term trading opportunities in the market, but is also used for fine-tuning entry and exit points of long term trades. Thus, it is more about finding short term repetitive trading opportunities, to give you consistent returns. One of the most important things to keep in mind is that in technical analysis we are dealing with probabilities, not certainties. So it is a good habit to practise it with strict stop losses.

Risk & Return - Sides of the same coin

There is an inherent relationship between risk and return. High returns can’t be achieved without taking appropriate risks. If you read autobiographies of any of the people who made it big in their lives, you would realize that all of them would have taken appropriate risks at different points of time. Same thing applies in the financial world also. Any rational person will be willing to take more risk, only if it comes with a promise of better returns. Let’s start our discussion with an example.

Horse betting is a game loved by many across the globe. It’s a fun game and if you are lucky, you can make some quick bucks. Let’s assume there are 10 horses participating in a race and we need to place our bet on one of them.

	Horse 1	Horse 2	Horse 3	Horse 4	Horse 5	Horse 6	Horse 7	Horse 8	Horse 9	Horse 10
Multiplication Factor	21	15	8	9	36	42	3	99	81	50

Above table lists the multiplication factors of each of the 10 horses. Multiplication factor represents the factor applied to your investment, if you win the bet. So if you put INR 30 on Horse 3 and it wins the race, you would receive INR 240 – your money will grow 8 times the initial investment. Let’s try to answer why the multiplication factors of horses are different. The horse with highest number of wins in the past will have the lowest factor, because it’s most likely that it will win the race again (low risk, low return). The horse with lowest number of wins will have the highest factor, as probability of it winning the race is low (high return, high risk). So if you bet INR 1000 on horse 10 and it wins the race, you would make INR 49,000 in just few minutes. You are rewarded more, because you took a risky and unlikely bet. It doesn’t mean that you should take risky bets. It means that if you take risky bets and win, you would be rewarded more.

Horse 7 has the lowest multiplication factor, as it has historically been most consistent in winning races. We can say that its performance is less volatile. On the other hand, Horse 8 has very high multiplication factor, as its performance has been very inconsistent in the past. We can say that the performance of Horse 8 is very volatile. If we were betting on stocks instead of horses, then these multiplication factors would represent expected returns. As discussed, betting on horse 7 was less risky due to its consistent nature, similarly betting on stock 7 would be less risky, due to its low volatility. But the return that can be expected from this stock would also be low. Generally, more volatile the returns (performance) of a security are, more risky it is.

The concept becomes clearer in the chart below.

We have plotted the daily return of two stocks (A,B). We can clearly say that stock B is less volatile, more stable and less risk than stock A. With stock A, we can end up making as high as 28% in a given day or as low as -40%. With stock B, this range shrinks to -6% to 5%. With stock B, our returns are more stable and we lose less when the market falls. But at the same time, we gain less when the market rises, as we had avoided taking that risk.

PE Ratio

Price-Earnings Ratio

Let’s assume 1 kg of wheat costs Rs.X at the nearby supermarket. Now suppose, 1 kg of wheat represents one unit of a company’s earnings and price of Rs.X represents the market price of 1 share. So when you pay Rs.X to buy 1 share of a company, basically you are buying 1 unit of company’s earning by paying Rs.X. PE ratio is the price paid per unit of earnings and is calculated by dividing current market price by earnings per share. In our example, PE ratio would be X as X/1 = X.

You might have read that PE ratio of a stock is 25 or Nifty is trading at a PE ratio of 16. You might naturally wonder why anybody would pay that much to buy Rs.1 earnings. So it is important to understand that when you pay money and invest in a company,  you are eligible to receive a part of the earnings generated by the company, every year, as long as you hold the share.   

Suppose the price of 1kg wheat of brand A is Rs 15 and that of brand B is Rs 20. You believe that both A and B are equally good quality wise. So naturally you will buy brand A wheat as it is cheaper. Similarly, let’s suppose there are two companies operating in the same sector and are expected to perform similarly in the future . A has a PE ratio of 18 and B has a PE ratio of 20. We can easily say that A is undervalued compared to B as it has lower PE ratio. It would be prudent to buy shares of A as we have to pay lesser amount per unit of earnings compared to shares of B.

Just as price of 1 kg wheat cannot be meaningfully compared to price of 1 litre of petrol or any other product for that matter, PE ratio of companies operating in different sectors cannot be meaningfully compared. Only PE ratio of companies operating in the same sector can be meaningfully compared to each other. One can also compare the current PE ratio of the company with its historical PE to deduce whether the stocks is currently undervalued/overvalued.

RoE

Return on Equity

It is the income generated per unit of equity invested, i.e. how much returns shareholders/investors are getting on the money invested by them in the company. Please note that not all returns will be credited to the investor’s account. The company might decide to return only some amount as dividend and retain the rest for future investment purpose.  However since all profits generated by the company, technically belong to the investors we use the same for return calculation.

                  ROE = PAT (income statement) / Total shareholder’s equity (balance sheet)

It is usually expressed as a percentage. In case of ABC Inc, it would be 24% (ROE = 12000/50000 = 0.24)

Let’s consider an example to understand how the ratio can be used by individual investors. Suppose you have Rs 5000 and are contemplating whether to invest in ABC Inc or a bank fixed deposit. Bank is offering 10% returns for a one year fixed deposit. However you are aware that ABC Inc. generated 24% returns last year. If you believe that ABC Inc. will continue to perform well and be able to sustain its profitability, then the company will probably generate 24% returns next year as well. Hence it would make sense to invest in ABC Inc. compared to bank fixed deposit.

One argument against investing in ABC Inc. is that past performance doesn’t guarantee any future performance and that the company might not generate high returns next year. But suppose ABC Inc. has continuously generated ROE of 24% over the previous 5 years, then there is a good chance that company might do this in the future as well. One should always look at the ROE history of a company to understand how much returns can be expected in the future. ROE also helps in comparing two different companies. However please make sure that  only apples are compared to apples, i.e. similar companies from same sectors should be compared to each other.

Financial Statements (i)

Why assets are always equal to liabilities

Financial statements are used to gauge the health of a company. It’s always good habit to learn about a company before investing in the same. Financial statements can give us a quick snapshot of how much profit the company has been making over the years; how much of that profit has been returned to investors in the form of dividends; what are the liabilities and whether the assets are sufficient to fulfill these liabilities? Let’s discuss more about income statement and balance sheet, the two most important financial statements of a company. Let’s try to understand everything through an example.

Let’s assume you want to set up an auto parts manufacturing plant and need some money for the same. You have three options to raise funds:

Option 1: Take a loan at a fixed rate of interest from the local bank

Option 2: Take money offered by your dad’s friend and bring him on board as an investor/shareholder

Option 3: A mix of the above two options

Let’s say you opt for the third one. Your total initial requirement is Rs 1,00,000. You have decided to take a loan of Rs 50,000 from the bank and borrow the remaining Rs 50,000 from your dad’s friend. You intend to use the funds for the following purposes: Rs 40,000 for machines, Rs 40,000 for building & other infrastructure and Rs 20,000 for raw materials.

At this point, let’s define some basic terms. All the tools, machines, infrastructure, building and other things acquired by you for manufacturing auto parts are called assets. More precisely, everything bought and owned by you using the money you raised, is classified as an asset. Assets are created when funds are utilised to buy articles that are going to help generate cash in the future. In this case, machines are acquired using the funds you raised and will help you generate cash in the future.

Assets can be further broken down into fixed, tangible & immovable assets and movable current assets. Plant and machinery will be classified as fixed, tangible and immovable assets because they are relatively immovable and have a very long life. Raw materials will be classified under movable current assets, as they have a very short life span and will be required to replenish at regular intervals.

Whereas assets are sourced by using funds, liabilities are the source of funds. As discussed, we have two sources of fund: banks and your dad’s friend. Total liability is Rs 1,00,000. The most important thing to understand here is assets are always equal to liabilities. The amount you borrowed from bank needs to be repaid over the next few years and will be classified as long term liability. Money you raised from your dad’s friend is not a loan but an investment in your company. Thus it is classified as shareholder’s equity and your dad’s friend will be a shareholder of the company.

So to conclude and summarise, assets are obtained by using funds and liabilities represent sources of funds. Hence assets are always equal to liabilities.

Market Index

Understanding Sensex & Nifty

We have understood what an exchange is and how we can trade on the same. In this article let’s discuss “market index”. We keep reading in newspapers that Nifty is up or that Sensex is down. Let’s try to understand what these up and down movements actually mean. Nifty and Sensex are the market indices of National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) respectively. The market index is what is most commonly tracked and followed by all market participants to get a broad understanding of general direction of market movement.

Let’s try to understand this through an example. Suppose you want to understand the price movement in real estate sector in a particular city. If a property buyer offered you a high price for a piece of property that you bought last year, and based on the same you conclude that real estate price across the city is trending up, then there is a high possibility that you are wrong. There are different types of properties available in the market: agricultural land, commercial land, residential land, office space for renting, bungalows, flats etc. There are a multitude of reasons why price of any of these types of properties might be increasing/decreasing. Some of the reasons causing price movement might be common to all types of properties and other reasons might be affecting only specific property type. In general, when population is increasing in a locality and land is becoming scarce, prices of all kinds of properties go up. So this is a common factor affecting all kinds of properties. But there might be a situation where demand and price of commercial properties are decreasing because companies are shifting their base out of the city, while demand and price of residential flats are increasing because people, whose personal income is increasing, are buying second homes. Thus, if we want to conclude something about the real estate market in a city, we cannot do that just by looking at price movements in a single locality or in a single property type. However if we create a representative basket which includes some properties from all these types and from different location across the city, then we will be able to better observe general price trends and conclude direction of price movement in the sector.

A market index serves as a benchmark that allows us to understand general price movement of stocks on the exchange. As discussed in the first article, many companies are listed on the stock exchange. If we just look at price movement of one company to decide general trend in price movement across market, our conclusion will most likely be incorrect. First we will need to create a basket of sample stocks as was suggested in the earlier example. Including most frequently traded stocks from different sectors of the market like banking, pharma, IT, metals etc. will give best results. Once the basket is created we can observe the price movement of the stocks within, to conclude the general price trend of the market.

Nifty is a sample of 50  listed and frequently traded stocks on NSE, selected from across different sectors. Similarly, Sensex is a sample of 30 stocks from across different sectors all listed on BSE.

Read on to understand what an index is and how it is  constructed.

Exchanges

Drivers of economic growth

Stock exchanges are marketplaces where shares are bought and sold. Companies looking to raise funds can issue shares on stock exchange, i.e essentially sell shares. Market Participants (other companies, retail investors, banks, insurance firms etc) buy these shares, allowing sellers to raise the required amount. Once shares are bought by market participants the shares are considered to have gone “public”. These shares can now be bought and sold at will on the stock exchange by the market participants. Price of each share is determined by laws of demand and supply. Higher the demand, greater the share price and vice versa. Most of the trading in India takes place on two major stock exchanges, namely the BSE (Bombay stock exchange) and the NSE (National stock exchange). NSE is the biggest stock exchange in India, in terms of total volume of shares bought and sold.

Like shares, other instruments such as options, futures,bonds etc. are also traded by market participants on exchanges. Only registered market participants/members can trade on stock exchanges. So when retail investors want to buy or sell shares they need to do so through these registered members, who are called “stock brokers”. These brokers get the investor to open an account with them, which allows them to access all the required details of the client. Stock brokers then act as middlemen between investors and exchange and facilitate buying and selling of shares, in return they charge a brokerage fee for their services.

Exchanges play a very important role in the economic growth of the country. Economy grows when new jobs are created, new jobs are created when companies open new factories, new factories are opened when firms have sufficient funds required to make these investments and exchanges help these firms raise funds for investment.

Let’s now understand how trades are executed and orders are placed at an exchange.

Basics of Trend, Support & Resistance

In our previous article, we explained the rationale behind trend. It’s a pattern identified by technical analysts to predict future price movements of a security. In the example that we covered in last article, we stood at a signal for 2.5 hrs to identify various trends. Similarly, we can analyze any stock for a specific time period to study and identify trends. For better understanding, we recommend reading the above article before going ahead.

Trend: A trend is defined as a general pattern or direction followed by price of a stock in a specified time period. As discussed in the previous article, a stock price never moves in a straight line. It generally follows a random pattern with successive highs and lows. But over a period of time, price of a stock can move up or down. If the price seems to be heading upwards, it’s called an uptrend. If the price seems to be heading downwards, it’s called downtrend. It might also happen that we are not able to recognize any pattern, as happened in the middle portion of the chart that we explained in last article. Usually, a trend is classified as a long term trend, if it lasts for more than a year. Short term trends are the ones which last for around 1-2 months. There could be multiple short term trends in a long term trend. A stock might be in a long term uptrend which has been observed over the last 5 years, but currently experiencing short term downtrend due to factors which are not expected to last long.

Support and Resistance: We obtained resistance by joining all the highs and support by joining all the lows, in the chart created in previous article. As seen in the chart, no. of cars moved between these two lines. Similarly, when we plot support and resistance by joining lows and highs of a stock price and determine a trend, we expect the stock price to move between these two lines. If the stock price moves below the support line, it means that the trend has been broken and there is excess downward pressure on the stock. Similarly, when stock price moves above resistance, again trend has been broken and there is excess upward pressure on the stock. In an uptrend, this could happen because the speed of increase in no of people interested in buying stock has increased. Suppose in our previous example, instead of 30 cars coming and joining the queue in every 5 mins, 40 cars are coming and joining the queue after 6:30 pm. In this case we would get the following chart. We can easily see how the resistance is broken and line depicting no of cars move out of trend due to excess upward pressure. Same thing can happen with a stock price, when the speed of increase in no of people interested in buying stock increases.

We defined price and volume as the two important indicators tracked and studied by technical analysts. Read our next chapter to understand how volume is used in technical analysis.

Types of Charts

In our last article, we learnt about construction and importance of charts in technical analysis. In this article, we will be covering various types of charts, frequently used in technical analysis. Before we go in details of these charts, let’s first quickly understand few terms associated with price of a security (shares/bonds/derivatives)

1. Open price: price at which first trade happens, after market opens for the day
2. Close price: price at which last trade of the day happens. Sometimes, it’s the average price of last few minutes
3. High price: highest price attained by the security, during the daily trading session
4. Low price: lowest trading price during the daily trading session

• Line chart

It is constructed by joining various data points at different time intervals through a straight line. As discussed in the last article, no of data points varies according to unit chosen for horizontal axis. Below is the line chart that we discussed in our last article. It is constructed using last 3 months daily close price and has day as the smallest unit on horizontal axis.

• Bar chart

It shows a lot more information, compared to a line chart. In line chart, we joined all the data points using a straight line. Here, we don’t join these data points. As shown in the chart below, at each unit of time (horizontal axis), a vertical line is constructed. So for the same Maruti chart that we plotted above, a bar chart will have 90 vertical lines for 3 months – one line for each day. Top most point of the line shows high price of that day. Bottom most point depicts the low price of daily trading session. Also, you can see a small horizontal dash cutting each of the vertical lines. It represents daily close price. If we join all the points at which these small dashes are cutting vertical lines, we will again get the line chart that we discussed in our previous point. Apart from high, low and close price information, there is one more very important thing that bar charts convey. The length of each vertical line shows the extant of daily price movement. If the length is very high for a particular day, it means that there is big difference between highest and lowest prices attained during that day’s trading session. Thus, a stock would have experienced high volatility in that trading session.

• Candlestick chart:

As discussed in the previous point, bar chart shows information about high, low and close prices. In addition to this, a candlestick chart also shows information about the open price. Again, a vertical line is placed for each of the data point. So if we are using day as the smallest unit on horizontal axis, we will be adding one vertical line for each day. Similar to bar chart, top point of the vertical line will depict high price and bottom point will depict low price. But instead of dash, now we add a bar on top of the vertical line, as shown in the chart below. These vertical bars can be hollow/white or filled/black. A hollow bar tells us that close price is higher than the open price. In this case, upper end of bar chart will show close price and lower end will show open price. Length of the bar will depict difference between open and close price, while length of the line will depict difference between high and low price. On the other hand, a filled bar represents a scenario where close price is less than the open price. Here, lower end of the bar will show close price and upper end will show open price. Thus, upper and lower end of bars always represents close and open price, but which will depict what depends on whether it is filled or hollow.

There is a lot more information conveyed by a candle chart, apart from the four price points that we discussed. Let’s take an example. Suppose everyday there is a fight between a bull and a bear. All the information about this daily fight is conveyed using a candlestick chart. In this case, following would be the interpretation of different characteristics of a candle chart

• If bull wins the daily fight, it is represented by a hollow bar
• If bear wins the daily fight, it is represented by a filled bar
• The intensity of the fight is represented by the length of the line
• Length of the bar represents margin by which either one wins

Now suppose bull means buyers in the market and bear means sellers. Every trading session is a fight between buyers and sellers. If buyers win, stock price increase and close price is above the open price. Thus, we get a hollow candle. It shows that buying pressure on the stock was much more than the selling pressure, and length of the bar represents extent of difference. If sellers win, it means selling pressure was more during the trading session and closing price would be less than the open price. This would be represented by a filled bar. If we are continuously getting hollow candles, in our example this would mean bear has become weak, as it is losing every day. Similarly, in real life it would mean that buyers are outnumbering sellers and there is strong bullish momentum in the stock. Opposite will happen in the case of filled candles.

Fundamental Analysis

Following the herd isn't always bad

As explained above, Technical Analysis deals with the study of historical patterns in price and volume data. On the other hand, Fundamental Analysis requires examining various characteristics (fundamentals) of a company and determining what should be the price of its share. Once the price is determined, we can use this derived price to compare it with the current market price. If the price determined through fundamental analysis is lower than the current market price, then stock is currently overvalued and price is supposed to come back to the fundamental price in long term. Thus, we should sell the stock. On the other hand, we will buy a stock when the price determined through fundamental analysis is more than the current market price, as we expect the price to move towards fundamental value in the long term. Let’s take an example to make this difference between fundamental and technical analysis clear.

Suppose you want to buy Bluetooth speakers. There are many brands available in the market and you are not sure which one to pick. In this scenario, you have following two options:

Option 1:

Visit the showrooms of all brands, try out different variants, do the bargaining and finally buy the product when you are satisfied.

Option 2:

Go to any online shopping portal (market) and check out which model has received highest rating. Online portals have this option where users can rate the model, based on their personal experience after buying. In this process, you don’t need to go to each showroom to bargain and try different variants. All the hard work is already done and you just need to buy the product with highest rating, believing that users who have rated the product have already done all the analysis and are happy with their purchase. In this option, chances of you getting a good deal on Bluetooth speakers are very high.

Option 1 is similar to Fundamental analysis where you research few companies thoroughly before making your decision. The advantage is that it will help you understand business of the company where you are putting your hard earned money and you will be more confident about your investment. At the same time, the problem with this technique is that you can only research few of the companies and there is a high probability that you might miss some of the best trading opportunities.

Option 2 is very similar to Technical Analysis where you look for patterns and preferences in the market. The biggest advantage of this method is its scalability. You can quickly and easily apply this method on various stocks and asset classes to pick your investment. However, following the herd may not be a good strategy always 🙂

PB Ratio

Price-to-Book Ratio

Let’s first understand book value of a stock. Book value broadly represents the amount that a shareholder can recover from a company if the company decides to shut its business today. From our articles about balance sheet items we are aware of the terms assets and liabilities. Suppose a company XYZ Inc.is shutting down its business, it will have to sell all assets and recover money and at the same time it will have to repay all its loans and liabilities. Let’s assume XYZ Inc. received INR 500 crore through asset sale and has a liability of INR 300 crore in the form of bank loans. After paying back the loans, the company will have INR 200 crore left which can be distributed to owners/shareholders. In this case book value of XYZ Inc is INR 200 crore. If the company has 20 crore shares outstanding, each shareholder will then receive INR 10 (200/20) which is the book value per share. Now suppose XYZ is a publicly listed company and the current stock price is INR 15. Price to book value ratio is defined as the current price divided by book value per share. In XYZ Inc.’s case price to book value ratio would be 1.5. This means that you need to pay more to buy a stock, than what will accrue to you if the company decides to shut down its business today.  Investors will buy at this price only if they believe that in future, value of net assets will grow as company progresses. If the value is below 1, then it usually means that investors do not believe that the company will be able to recover the book value.

Price to book value ratio of less than 1 could indicate that the stock is undervalued and it is a good investment opportunity. The ratio could also be less than 1 because investors believe that the company will not do very well in the future and might not be able to recover the amount represented by the book value. Hence it is prudent not to base investment decision on just PB ratio. And just like in the case of PE ratio, PB ratio of 2 different companies can be compared only if they operate in the same sector. A company’s current PB ratio can also be compared with its historical ratio.

Dividend Yield

Let’s assume, ABC Inc is listed on National Stock Exchange (NSE) and has a stock price of Rs 100. Total number of shares issued by ABC Inc is 500. Dividend yield is defined as the ratio of dividend per share to price per share (commonly expressed as %).

                                                   Div. yield (%) = DPS / Price

            where DPS is total dividend declared by the company/total number of shares

In case of ABC Inc, DPS = 2000/500 = 4. Hence dividend yield of ABC Inc = 4/100 = 4%.

When you buy shares of any company, there are two different types of returns that you can expect, capital gains and dividend income.

Suppose, you buy one share of ABC Inc today at a price of Rs 100 and sell it back after one year at a price of Rs 125. In this case, you will generate a capital return/price return of 25% (125/100-1). Suppose ABC Inc. declares a Rs.4 dividend during this period your total returns will be Rs.29 (price return + dividend return). It’s very important to understand that when you invest in shares, your total return is not just the price return, but price plus dividend return. Dividend yield is a measure of the second type of return. It is an indication how much dividend can be expected on the investment. In ABC Inc.’s case an investor can expect to get Rs 4 as dividend on an investment of Rs 100.

As discussed earlier, an early stage company might not pay dividends and might retain its profit for future investment purpose. So in this case, dividend yield will be zero. But we know that dividend is just one part of the return. Stock prices of growth companies grow fast in response to company’s higher growth rate, thereby generating substantial capital gains.  One should always consider dividend yield when investing in a company’s stock, as it can be significant part of the return that might be generated. High dividend yield stocks are a good investment avenue to supplement your income needs.

Financial Statements (ii)

Understanding capital structure of a firm

In our previous post, we discussed the basics of financial statements and learnt about two basic items in a balance sheet: assets and liabilities. We also understood how assets and liabilities of a company are always equal. In this article, we will continue with our earlier example where we were trying to setup an auto parts manufacturing plant.
Let’s say you decide to name your firm ABC Inc. As discussed in the previous article, total assets of ABC Inc. is worth Rs 1,00,000 and total liability is also equal to Rs 1,00,000. We further classified assets into current assets and fixed & immovable assets. Liabilities were classified as shareholder’s equity and long term bank liability. Please refer to the table below to understand basic structure of ABC Inc’s balance sheet.

Assets		Liabilities (incl equity)
Fixed Assets		Shareholder Equity
Plant Building	40,000	Friends of father	50,000
Machines	40,000
Current Assets		Liability
Raw Material	20,000	Bank Loan	50,000
Total	1,00,000	Total	1,00,000

Assets are sourced by using funds, liabilities are the source of funds. As discussed earlier and as can be seen from the above table assets are always equal to liabilities. Lets now discuss few other few commonly used terms: debt, equity and leverage.

Debt is a liability and refers to the the amount of loans raised by the company on which it is has to pay interest every financial year. In our example ABC Inc. this is equal to the amount of Rs.50,000 taken as loan from the bank. Equity refers to the initial investment put in by different investors/shareholders. In this case, it would be equal to Rs 50,000 investment put in by your dad’s friend. A company can raise more funds through equity route by issuing new shares. In such a scenario equity will increase by a proportionate  amount. Leverage is the ratio of debt to debt plus equity (debt/(debt+equity). In ABC’s case leverage is 50% (=50000/100000). Hence ABC is 50% levered. The debt/equity ratio of 1:1 or 50%:50% in this case, is also known as the capital structure of the firm. It tells us how much debt company has borrowed, compared to equity.

The above explanation completes our discussion on basics of balance sheet. Read on to learn about income statements.

What is an Index?

The representative sample

We have discussed what a market index represents and why we track it. In this post let’s learn more about the market index.

The term index usually refers to a basket of some finite assets (stocks/bonds/commodities etc) which as a group forms the best representation of the space in which many similar assets lie. Let’s say we want to create an index to represent Indian IT industry. As per our definition of index, this should be a basket of IT companies that best represent the IT sector. There are many IT companies listed on the exchange, so the natural question is which companies should be selected to be included in the basket? It’s important to define some basic terms at this point

Shares Outstanding = Total number of shares issued by the company

Market Cap = Current Price * Shares Outstanding
(This tells me what is the current value of a company)

Suppose a company X has issued 100 shares and the current price of each share is Rs 10, then the market cap of company X will be Rs 1,000. It means that the total value of the company (cumulative value of all shares) is Rs 1,000. Each listed company in IT sector will have its own market cap/value. If we add all these market caps, we will get the total market cap of IT sector ie combined value of all the listed companies in the IT sector.

Let’s revert to the question of selecting stocks for our Index. Let’s say there are 1000 companies in the IT sector. 10 companies, out of 1000, are very big and represent almost 90 percent of the total market cap of the sector. So the combined market cap of the other 990 companies will amount to only 10% of the sector market cap. Since 10 companies represent most of the market cap of the sector, we could just select these 10 to form a representative basket of the IT industry.

Suppose I want to invest in this IT basket and I have Rs 1000. If I decide to invest equally in all the 10 stocks, I will end up buying Rs.100 worth of shares of each one of these 10 stocks. Let’s assume Infosys is one of the stocks that I hold and I have Rs.100 worth of the company’s shares. So the company has a weightage of 10% (100/1000) of my investment amount.  Stock weightage is equal to value of investment in the stock divided by the total value of all investment. As I invested equally in all the 10 stocks, weightage of each of the stock in my portfolio is 10%.

Let’s assume that at the time of investment each share of Infosys cost Rs.50. Since I invested Rs.100 into the stock I would have got 2 (100/50) shares. Similarly with an investment of Rs.100 in each stock, I would have bought some fixed number of shares of each company.  Suppose after 2 days prices of all stocks except Infosys’s price remains unchanged. So leaving out the value of Infosys, the balance investment is still worth Rs.900. If the price of Infosys has shot upto Rs.90 from Rs.50 over the last 2 days, my investment in that company will now be worth Rs.180 (90 * 2 shares). Total value of investment of all 10 stocks would be Rs.1080 (900+180). Please recall we defined weight of each stock in the portfolio as value of investment in the stock divided by the total value of all investment. Hence weight of Infosys will now be 180/1080 = 16.67%. To make up for the increase in weight of one stock, weightage of all other stocks would have dropped down to 100/1080 = 9.26%.

The important takeaway from this example is that when we create an index or buy a basket, number of shares of each stock remains constant, however weightage of each stock does not. Weightage represents the portion of total value represented by a single stock and as the stock price changes everyday, weights do too. Let’s continue with our example in the next post.

Trading Mechanisms and types of orders

In our previous post, we discussed how exchanges facilitate buying and selling of shares between market participants and the role of brokers in the process. In this article let’s discuss how orders to buy/sell shares are placed on an exchange.

Let’s assume you decide to buy 1 kg of tomatoes from the nearby vegetable market at not more than Rs.10/kg. You go to the market and see that there are five vendors, all selling tomatoes at Rs 15/Kg. You start negotiating with each one of them and realize that there can be two outcomes:

Outcome 1: Just like you other customers are also demanding lower price. Seeing this vendors will start reducing the price, as nobody is willing to buy tomatoes at Rs 15/kg. It might happen that the price comes down to Rs 10/kg and after buying 1 kg tomato you go home happily,

Outcome 2: Unlike you, others are willing to pay the price of Rs.15/kg demanded by vendors. As vendors will be able to clear their stock at higher price, prices will never come down. In this case you won’t be able to buy tomatoes at Rs.10/kg and will return empty handed.

In the above example, you are the buyer, tomato vendors are the sellers and tomatoes are the commodities (underlying). Similarly on the exchange, there are many buyers and sellers and the underlying could be anything: stock, bond etc. The entire trading process takes place on an electronic system where buy and sell orders are matched. Just like in our example, suppose now you want to buy 1 share of a company A at Rs 100, currently trading at a price of Rs 108. Lets us discuss the different types of orders that can be placed to execute the above order.

Types of orders

Limit Order: You can key in an order into your computer to buy 1 share of company A at Rs.100. Just as in our earlier example there are 2 possibilities. If lot of people are demanding shares of company A, at Rs.100 and nobody is willing to pay the current market price of Rs.108, prices will automatically come down to match demand and you might be able to buy at Rs.100 or even lower than that. However if other buyers are comfortable paying Rs.108, then prices will not come down to your desired level and you will not be able to buy the shares. In a limit order, the order will get executed at your desired price or at a better price – i.e. at the limit price or a lower price in case of a buy order, and conversely, at the limit price or a higher price in case of a sell order. This order type is advantageous when the investor wants to buy/sell at a particular price and does not mind waiting for that price.

Market Order: In this case you key in an order to buy/sell the shares immediately at the current market price. Your priority is speed of order execution and you do not care about the direction of price movement. In this case you might end up buying at a higher price or selling at a lower price, as price might increase/decrease by the time order is executed.

Stop Loss order: This is a risk averse investors favorite. Suppose after buying the shares at Rs.100 you are now concerned that the price might fall further and do not want to make a huge loss. So you can enter a stop loss order at a price lower than your purchase price. Let’s assume you do not want to lose more than Rs.5 on your purchase, a stop loss order can be put in at Rs.95. If the price starts to trend down and hits Rs.95 shares will be sold and your loss will be minimised to Rs.5.  

Duration order: This order variety allows you to specify the time till when the order you placed stays open. Let’s suppose you enter a limit order and make it “Good for the day”. In this case, if the order is not executed by the end of the day then it will automatically get cancelled. However if you place “Good until cancelled” order, then the order will remain open/active until the price comes down to your desired level and you are able to buy the share.

 

Technical Analysis (ii)

Price reflects everything

Let’s try to understand more about technical analysis in this post. In our first post on technical analysis, we introduced what technical analysis is and how it helps you make a good point of view about any trade/investment. Here we will be focusing on versatility of technical analysis and some assumptions which are used while applying technical analysis.

Consider an analogy. Think about learning how to swim. Once you learn swimming, you can literally swim anywhere. On the similar lines, Technical Analysis (TA) is the skill you need to learn just once and you can apply this across different asset classes. By asset classes, we mean stocks, bonds, currency, commodity etc. The underlying concept of Fundamental Analysis will keep on changing, depending on the asset class, whereas the basic concepts of Technical Analysis will remain same irrespective of the asset class.

Before going into how it works and how it should be applied, let us look at some of the assumptions used in the technical analysis

1. One of the most important assumption of Technical Analysis (TA) is that price reflects everything. It means that price of a stock will contain all the information and if you are analyzing it, then you don’t need to analyze other factors. You must be thinking how this is possible, as there are many factors like profit, balance sheet, management which affects a company. But technical analysis assumes that just like you, other investors in the market also know these things and have already studied these factors. Thus, as others already know about these factors, the price has already changed to reflect it, assuming that they would have already acted upon this information.
2. Technical analysis assumes that price movement follows a trend. Once a trend is established, it is expected that price will move in the same direction, unless trend changes. If using technical analysis you have concluded that a stock is in uptrend, then the price will keep on increasing unless the uptrend is reversed. We will be learning about finding and establishing these trends, in following articles.
3. Technical Analysis believes that history repeats itself. This means that patterns in stock price will keep on repeating themselves. The rationale behind this assumption is that investors and traders behave in the same fashion, again and again, when they are exposed to similar situations. So if there was some pattern observed last time, when price of a particular stock crossed 52 week’s high, it is likely that same pattern will be observed again because all the investors will behave in the same fashion, as they did last time, to this information.

To establish trends and patterns, and analyze market movements, technical analysts use charts. In the chapters ahead, we will be covering different types of charts used by technical analysts and the process of identifying trends and pattern.

Correlation

When it rains in Mumbai, India defeats Pakistan

Correlation represents how any two variables move together. Without going into its mathematical derivation, let’s discuss how correlation is used and interpreted in stock market. The value of correlation always lie between -1 and + 1 (-100% to 100%). If one were to declare that there is 80% correlation between rains in Mumbai and India beating Pakistan in a cricket match, what does it represent? It tells us that out of 100 cricket matches when India beat Pakistan, 80 times it simultaneously rained in Mumbai. Correlation number indicates nothing more or nothing less. So when we say that correlation between Stock A and Stock B is 80%, it means that out of 100 times when stock price of A increases, stock price of B will increase 80 times. The reverse can also be true that out of 100 times when stock price of A decreases, stock price of B will decrease 80 times. Thus correlation tells us what’s the probability of increase in stock price of B, when stock price of A has increased or what’s the probability of decrease in stock price of B, when stock price of A has decreased. Please remember correlation doesn’t tell anything about the extent of expected movement in a stock, based on movement in another stock.

NPM

Net Profit Margin

It is defined as the ratio of net income generated in a year to total sales / revenue.

                                                            NPM = PAT / Sales

In case of ABC Inc, NPM is 12% (12000/100000=0.12). This means that for every Rs 100 worth of auto parts sold by ABC Inc, a net income of Rs 12 was generated. As explained in our article on Income statement, we know that we need to deduct many items from total sales / revenue, to arrive at net income number. Items like cost of goods sold, interest, taxes and others are subtracted from total sales / revenue, to finally arrive at net income. The NPM ratio tells us how efficiently a company is converting its sales to profit. Better management of taxes, raw materials, inventory and operational efficiency can lead to substantial profits. Thus in case of two different companies of same size which operate in the same sector, the company which has higher NPM is more efficient, as it can generate more profits by selling the same amount of goods.

Financial Statements (iii)

A company's salary slip

In this article, we will be covering the other important financial statement of a company, called Income Statement.
Balance sheet gives us an idea about the assets and liabilities of a company, as of a specific date. All the items defined in a balance sheet are as of a specific date. On the other hand, items covered in the income statement give details about what has happened over a specific period of time. We will revisit this issue after understanding basics of income statement. Please refer to the below table to understand the basic structure of ABC Inc’s income statement

Item	Amount (in INR)	Description
Sales Revenue (a)	1,00,000	Amount of units sold in a year multiplied by the price per unit (1000*100)
COGS (b)	70,000	Amount of units sold multiplied by the cost in making each unit (1000*70)
Gross Profit (c=a-b)	30,000
SG&A (d)	10,000	General costs incurred in day to day operations: rent, utilities, insurance etc
EBIT (e=c-d)	20,000	Earning before Interests and Taxes are paid
Interest (@10%)(f)	5,000	Interest paid to the bank at the rate of 10% (0.1*50,000)
PBT (g=e-f)	15,000	Profit before taxes are paid
Tax (@20%) (h)	3,000	Taxes paid to the government @20% (0.2*PBT)
PAT (i=g-h)	12,000	Net income generated by ABC Inc in the given financial year
Dividends (j)	2,000	Dividends distributed to shareholders (friends of Dad)
Retained earnings (k=i-j)	10,000	Income reinvested in ABC Inc to expand the business

As can be seen in the above table, our starting point is total sales / revenue generated by the company over a specific time period, one full year in ABC Inc.’s case. Various costs incurred by the company during this period are subtracted from the sales number to arrive at profit after tax / net income.

A company can utilize profit after tax in 3 different ways:

1. Entire amount can be distributed to shareholders. In ABC Inc.’s case this would be your dad’s friend and you who are the owners/shareholders of the company.
2. Some part is distributed as dividend and some part is invested back into the company, for research and expansion purpose.
3. Entire profit amount is invested back into the company.

Early stage companies tend to retain most of the earnings as they have enormous potential to grow and capture market share. On the other hand, mature companies who have already grown a lot tend to distribute most of the income to shareholders in the form of dividends, due to lack of growth opportunities.

This clarifies how income statement includes items which give details of what has happened over a specified time period. For example, one cannot declare what is the revenue as of a particular date, because revenue is generated over a period of time. It is important to specify over what period this revenue is generated. On the other hand, one can always specify the amount of assets as of a particular date.    

Read our next chapter to understand how to quickly deduce important information from financial statements using key ratios.

What is an Index? (ii)

Impact of daily price changes on portfolio value

In the previous post we learnt about terms like market cap and shares outstanding. We also discussed how stocks can be selected to be included in an index and how in a basket of stocks though number of shares remains constant, weights keep changing due to price change.  

Let’s continue with the same example of IT industry.  We had selected 10 stocks, representing 90% of the total market cap of IT industry, to be included in our basket/index.  Now suppose instead of 10 stocks we want to retain only 5 stocks in an equal weighted basket. Weight of each stock would then be 20% and a Rs.1000 investment in this basket would result in Rs.200 investment in each stock.   

Let’s assume instead of equal weights, I assign different weights to the stocks and allocate 30% weight each to 3 stocks and 5% each to 2 other stocks. If I now invest Rs.1000 in the index, Rs.300 each will be allocated to the stocks with 30% weightage and Rs.50 each to 2 stocks with 5% weightage. Lets again recall that stock weightage is equal to value of investment in the stock divided by the total value of all investment.

Let’s assume you invest Rs 5000 in an equi-weighted index of 5 stocks. Each stock will have a weight of 20% at the time of investment and will be allocated Rs 1000. Let’s see what happens as the share prices of stocks change on subsequent days.

Investment Day

Stock	Share price	Initial investment	Shares	Value of investment (share price * shares)	Weight (Total value / individual value)
A	100	1000	10	1000	20%
B	100	1000	10	1000	20%
C	200	1000	5	1000	20%
D	200	1000	5	1000	20%
E	500	1000	2	1000	20%
		Value of investment		5000	100%

Investment Day +1 (Next day, prices of all the stocks will change, but the no of shares will remain same) 

Stock	Share Price	Initial Investment	Shares	Value of Investment (Share price * Shares)	Weight (Total Value/Individual Value)
A	120	1000	10	1200	20%
B	150	1000	10	1500	25%
C	200	1000	5	1000	17%
D	250	1000	5	1250	21%
E	550	1000	2	1100	18%
		Value of Investment		6050	100%

Investment Day +2 (prices will change again, but the no of shares bought will still remain same)

Stock	Share Price	Initial Investment	Shares	Value of Investment (Share price * Shares)	Weight (Total Value/Individual Value)
A	150	1000	10	1500	21%
B	180	1000	10	1800	25%
C	220	1000	5	1100	15%
D	300	1000	5	1500	21%
600	600	1000	2	1200	17%
		Value of Investment		7100	100%

As can be observed, after we bought the index price of stocks and because of that weights of stocks within the basket kept changing. However number of shares will always remain constant. On day 1, at the time of investment, value of my portfolio was Rs 5000. On day 2, it changed to Rs 6050 and on Day 3 it changed to Rs 7100.

To understand how to calculate profits and arrive at an Index value, read on.

 

Beta

Beta is a measure of risk. To understand this, first let’s understand two types of risk faced by a company. Let’s take the example of Maruti Suzuki. Sometime back, it had a labor strike in its Manesar plant. This hampered production and tarnished Maruti’s image. Due to this, investors started moving away from Maruti’s stock and it experienced sharp fall. This was a Maruti specific risk, as only the stock price of Maruti was impacted, not the other stocks trading at the exchange. This type of company specific risk faced by a stock is called unsystematic risk. In this case, if I had put all my money in Maruti’s stock, definitely I would have been hospitalized. But if Maruti was a small part of my portfolio, then I might have suffered a small loss. That’s why we say that company specific risk can be avoided by investing in various unrelated stocks, i.e. having a diversified portfolio.

The second type of risk faced by a company is called Market Risk. Suppose there is a political party called CNG headed by a very weak politician. The party is generally viewed as non-progressive and against modern reforms, required to bring in rapid economic growth. If such a party gets elected, then obviously prices of all the stocks will go down. This is not a company specific risk, but the general market risk. Irrespective of the fact that whether I have invested my money just in Maruti or have a big portfolio of unrelated stock, I would have experienced a significant loss. That is why we say it’s not possible to avoid market risk by investing in a portfolio of unrelated stocks, as all will be impacted by market events.

Beta is a measure of market risk. If the beta of a stock is more than 1, it means stock moves along with market in the same direction and is more volatile than the market. So if market is expected to increase by 10%, a stock with a beta of more than 1 is expected to generate more returns than 10%. Generally, in a bull market we invest in high beta stocks, to enhance returns. If the beta is less than 1, it means that stock is less volatile and not related to the market. These stocks are best bet in a bear market, to protect against sharp price drops.

Dividend Payout Ratio

This ratio tells us how much of profit is distributed to shareholders/investors in the form of dividends. It is calculated by dividing total declared dividends by PAT/net income.

Payout Ratio = Total dividends / PAT

In case of ABC Inc, the ratio would be 16.67% (2000/12000=0.1667). It tells us that only 16.67% of the profit generated by ABC was distributed to investors and rest was invested back in the company. As discussed previously, early stage companies tend to pay less dividends and reinvest more as they have more opportunity to grow. On the other hand, mature companies pay more dividends out of their profits as they have fewer growth opportunities. So early stage companies might have small payout ratios compared to large companies.

Apart from financial statement ratios, there are many other ratios like PE ratio and PB ratio which help us in making a better investment decision. In the next chapter we have covered some key ones.

Calculating Index Value

Simplifying return analysis

Let’s continue with the same examples that we used in the previous articles. We started out by creating an index for the Indian IT sector. We then learnt about market cap and shares outstanding. We then learnt about which stocks can be included in an index. We also discussed weightage of stock in an index/basket and how due to price change weights keep changing but absolute number of shares remain the same.

We also considered another example of buying a basket where Rs.5000 was invested in 5 stocks. We saw how the number of shares purchased were calculated and how the total value of investment changed due to change in stock price. On the day of investment, value of the total investment was Rs 5000. Next day, the value changed to Rs 6050 and the day after that, it changed to Rs 7100. In this post, let’s try to understand how the final Index value is calculated and how it should be interpreted.

While calculating an index value, we want to see how investment value has been moving on a daily basis compared to the base value. In our example the base value is Rs 5000 and we want to understand how much returns we have earned on this amount. If we change the scale and say that 5000 = 100, then 6050 would be (100/5000)*6050. This is basic unitary mathematics. The below table summarizes the calculation of Index values for subsequent days, when we change the initial base value to 100 from 5000.

Day	Investment Value	Index Calculation	Index Value
Investment Day	5000	(100/5000)*5000	100
Investment Day + 1	6050	(100/5000)*6050	121
Investment Day + 2	7100	(100/5000)*7100	142

Now we are clear about how an index is created, calculated and interpreted. Whenever creating an index, fix the initial value to a base number and then track progress of the investment by comparing it to the base value. Sensex has a base value of 100, fixed in 1978-79 and now it has increased to more than 25000. Similarly, Nifty has a base value of 1000, fixed on 3rd Nov’95 and has crossed more than 7500. You can easily calculate the returns that both the indices have generated, since their inception. On day one our Index value was 100 and on day two it increased to 121. Hence one day index return was 21% which can be verified by the following calculation (6050-5000)/5000 = 21%. At the end of day two our index value stood at 142 and this allows us to understand that we have made 42% returns over the previous two days. This can also be verified by the following calculation (7100-5000)/5000 = 42%.

It is prudent to create an index for your investments. Index creation allows one to easily understand returns and follow & track investments. Smallcase platform makes available easily trackable custom indices for your portfolio/investment. It’s time you upgrade the way you invest.

Types of Indices

Garnishing the portfolio

In the previous article we learnt how to create, track and understand an index. This article will discuss various types of indices one can create using different weighting methodologies. There are 3 different weighting schemes that we can use:

1. Price Weighted :  stocks in the index are weighted based on their prices,  stock with the highest price will have the highest weight

2. Market Cap Weighted : stocks in the index are weighted based on their market capitalization, stock with highest market cap has the highest weight

3. Equal Weighted : stocks in the index are equally weighted

Suppose you decide to invest Rs 5000 in 5 stocks – AA, BB, CC, DD, EE.

Initially at the time of investing on Day 1, price and market cap of stocks AA,BB,CC,DD and EE are Rs 10, 20, 30, 40 & 50 and Rs 2000, 3000, 15000, 10000, 5000 respectively. Let’s assume at the end of day 2,  prices of stocks BB and EE have increased by 50%, while prices of all other stocks remain constant. The tables below explain how value of your investment will change each day depending on the weighing scheme.

1. Price Weighted

Day 1

Stock (A)	Price (B)	No. of Shares (C)	Weight (D=B/150)	Value of Investment (E=D*5000)
AA	10	1	6.7%	333.3
BB	20	1	13.3%	666.7
CC	30	1	20%	1000.0
DD	40	1	26.7%	1333.3
EE	50	1	33.3%	1666.7
Total	150		100%	5000.0

Day 2

Stock (A)	Price (B')	No. of Shares (C)	New Weight (D=B/185)	Value of Investment (E'=E*B'/B)
AA	10	1	5.4%	333.3
BB	30	1	16.2%	1000.0
CC	30	1	16.2%	1000.0
DD	40	1	21.7%	1333.3
EE	75	1	40.5%	2500.0
Total	185		100%	6166.7

2. Market Cap Weighted

Day 1

Stock (A)	Price (B)	Market Cap (INR) (C)	No. of Shares (D=F/B)	Weight (E=C/35000)	Value of Investment (F=E*5000)
AA	10	2000	28.57	5.7%	285.7
BB	20	3000	21.43	8.6%	428.6
CC	30	15000	71.43	42.9%	2142.9
DD	40	10000	35.71	28.6%	1428.6
EE	50	5000	14.29	14.3%	714.3
Total		35000		100%	5000.0

Day 2

Stock (A)	Price (B)	No. of Shares (C)	New Weight (D=E/5571.43)	Value of Investment (E=B*C)
AA	10	28.57	5.1%	285.71
BB	30	21.43	11.5%	642.86
CC	30	71.43	38.5%	2142.86
DD	40	35.71	25.6%	1428.57
EE	75	14.29	19.2%	1071.43
Total			100%	5571.43

3. Equal Weighted

Day 1

Stock (A)	Price (B)	No. of Shares (C=E/B)	Weight (D)	Value of Investment (E=D*5000)
AA	10	100.0	20%	1000.0
BB	20	50.0	20%	1000.0
CC	30	33.3	20%	1000.0
DD	40	25.0	20%	1000.0
EE	50	20.0	20%	1000.0
Total	150		100%	5000.0

Day 2

Stock (A)	Price (B)	No. of Shares (C)	New Weight (D=E/6000)	Value of Investment (E=B*C)
AA	10	100.0	16.7%	1000.0
BB	30	50.0	25.0%	1500.0
CC	30	33.3	16.7%	1000.0
DD	40	25.0	16.7%	1000.0
EE	75	20.0	25.0%	1500.0
Total	185		100%	6000.0

At end of day  2 it be can see that the value of your investment is different, in each one of the above weighting scheme. In our example, price weighted methodology generated maximum return. However the outcome would have been completely different had the stock price fluctuated in some other manner.

At smallcase, you can easily pick the desired weighting scheme or use the one recommended by our platform. Picking the right weighting scheme is very important, as it can significantly impact your returns.

Sectoral Indices

In our previous article we talked about various types of indices one can create, using different weighting schemes. In this article, let’s understand a sector Index.

As the name suggests, sector index/benchmark tracks the performance of a particular sector. Let’s take the example of BSE AUTO Index. It is used to track the performance of auto sector companies listed on BSE. As discussed in our initial articles on index, an index should comprise companies from each segment of the sector to remove all biases. You can quickly revise our examples of real estate index or IT sector index, for better understanding of the same. In the case of BSE AUTO index, it includes companies from all segments of Auto sector: auto parts manufacturers, tyre manufactures, 4 wheeler manufacturers, 2 wheeler manufacturers etc. The objective of creating the index was to put together the best possible representative sample of auto stocks and then track them all together through an index value. Once a representative sample is selected, generally market cap weighting scheme is used to create indices. BSE Auto index allows us to track the happenings of the Indian auto sector as most of the Indian auto companies are listed on BSE. If we want to see what is happening to Auto sector in Germany or USA, we can follow the auto sector indices of respective country exchanges. We can also create a global auto index by considering all the auto companies listed on various exchanges. A select group of companies that best represent the global auto sector universe can then be short-listed to form a basket.

Let’s consider one more example and talk about Nifty Media Index. It’s a Media sector index and represents media companies listed on NSE. As discussed, first step is to select companies from all segments of the sector to make the best possible representative sample. Nifty Media includes broadcasters, printers & publishers, film production houses and other segments of the Media sector. Once companies are selected, weights are decided based on the market cap weighting methodology. The company with highest market cap will have the highest weight. At the beginning of Jun’15, index value of Nifty Media was 2108. The same value at the end of Jul’15 was 2452. Using this we can quickly say that Media sector generated a return of 16.3% (2452/2108-1), in these two months. Similarly, we can calculate the returns generated by other sectors and compare them with each other to know which sector is performing the best.

Generally, sector indices based on companies listed on BSE, have BSE as their prefix: BSE Auto, BSE IT, BSE Metals etc. Sector indices based on companies listed on NSE, have Nifty as their prefix: Nifty Pharma, Nifty Auto, Nifty Realty etc. Tracking these tailor-made, easy to use indices enables an individual to quickly ascertain a sector’s health, its historical performance compared to other sectors, and helps him make a better investment decision. Let’s now learn and understand about custom indices.

Benchmarking

Point of reference matters - Einstein

A custom index refers to an index tailored as per one’s specific needs and expectations. Although there are many readymade/standard indices available on stock exchanges, they might not always fulfil every individual’s need. To understand the meaning and applicability of custom indices, first we need to understand what we mean by benchmark/benchmarking.

There are always two ways of measuring performance: absolute and relative. Suppose you are participating in a 100m running race. After completing the race you have been told that you took 30 seconds to complete the circuit. This is an example of absolute measurement. However this piece of information does not allow you to understand whether you won the race. Hence it is not a useful way of measuring performance. But if you are told that you finished first, then you understand that your performance was good. Similarly if you are told that your timing was just 2 seconds slower than the race record, this can also be interpreted as good performance. These are examples of relative measurement. In the first case, your performance was measured relative to that of other participants and in second case measurement was relative to previous record.

In finance and investment world, performances are generally measured in relative terms and compared to a benchmark. The benchmark is generally an index, relative to which an an individual stock or basket of stocks performance is measured. Let’s say I define Nifty as my benchmark and invest in a basket of 5 stocks, called “my basket”. Suppose after a month, Nifty has generated a return of 5% whereas my basket has appreciated by 7%, then one can conclude that my basket outperformed Nifty by 2% (7% – 5%).

Let’s consider another example. I now want to invest in a few IT companies and over a period of time compare their performance with that of IT sector in general. Our post on “Sector Indices”, informed us that Nifty IT sector index is a good way of tracking the performance of Indian IT sector. Hence I define Nifty IT sector as my benchmark and invest in a basket of IT stocks that I feel will perform well going forward.  After few days, I see that my investment has generated a return of 10%, however my benchmark Nifty IT index has returned 15% during the same period confirming that my IT basket has underperformed the sector index. In other words the stocks that I bought performed poorly when compared to the IT sector in general.

It is prudent to always define a benchmark to measure the performance of your investments. If you are investments are in a specific sector then a sector index might be a good benchmark. However if your investments are sector agnostic, then broader indices like Nifty and Sensex might be good benchmarks.

Custom Indices

The smallcase way of investing

In our previous article, we discussed benchmarks in detail and acquainted ourselves with the concept of custom indices. Let’s discuss custom indices in some detail now. Although there are many ready-made/standard indices available on stock exchanges, they might not always fulfil investor’s need. Hence investors might want to build their own custom indices.

Suppose you believe that it is the right time to invest in pharmaceutical companies and want to buy select companies in the sector. The smallcase platform makes available a basket/smallcase/index called Pharmacase that allows you to take position in representative group of companies from the pharma sector. Pharmacase consists of 5 stocks  (AA,BB,CC,DD,EE) and has an equal weighting scheme. We know that in an equal weighting scheme, all stocks in the portfolio have equal weights; hence each stock in Pharmacase has a weight of 20%. However being a prudent investor you have done your research and believe that stocks BB and DD will perform better than other stocks in Pharmacase and you want to assign higher weights to these stocks. Your preference is to allocate 35% weight each to BB & DD and distribute the remaining 30% weight amongst the remaining 3 stocks. Please refer to our article on index to refresh your understanding about weights and weighting schemes.

So you now customize the index by assigning higher weights to stocks BB & DD and also decide to use Pharmacase as your benchmark. Assuming a total investment of Rs.100 and price of each stock to be Rs.10, the below table illustrates how the value of your portfolio will change, relative to the value of Pharmacase, if only prices of stocks BB and DD rise by Rs.1 after one day.

Pharmacase, Investment Day

Stock (A)	Price (B)	No. of Shares (C)	Weight (D=B*C/Sum[B*C])	Value of Investment (E=D*100)
AA	10	2	20.0%	20.0
BB	10	2	20.0%	20.0
CC	10	2	20.0%	20.0
DD	10	2	20.0%	20.0
EE	10	2	20.0%	20.0
Total		100 =sum(B*C)	100%	100.0

Pharmacase, Investment Day +1

Stock (A)	Price (B)	No. of Shares (C)	Weight (D=B*C/sum[B*C])	Value of Investment (E=B*C)
AA	10	2	19.2%	20.0
BB	11	2	21.2%	22.0
CC	10	2	19.2%	20.0
DD	11	2	21.2%	22.0
EE	10	2	19.2%	20.0
Total		104 =sum(B*C)	100%	104.0

Custom Index, Investment Day

Stock (A)	Price (B)	No. of Shares (C=D*100/B)	Weight (D)	Value of Investment (E=B*C)
AA	10	1	10.0%	10.0
BB	10	3.5	35.0%	35.0
CC	10	1	10.0%	10.0
DD	10	3.5	35.0%	35.0
EE	10	1	10.0%	10.0
Total		100 =sum(B*C)	100%	100.0

Custom Index, Investment Day +1

Stock (A)	Price (B)	No. of Shares (C=D*100/B)	Weight (D)	Value of Investment (E=B*C)
AA	10	1	9.3%	10.0
BB	11	3.5	36.0%	38.5
CC	10	1	9.3%	10.0
DD	11	3.5	36.0%	38.5
EE	10	1	9.3%	10.0
Total		107 =sum(B*C)	100%	107.0

As can be seen from the calculations above, had you followed the trend and invested in Pharmacase, at the end of day 1 you would have ended up with Rs.104. But by customizing the index, you ended day 1 with Rs.107.  You outperformed the benchmark by 3% (7%-4%). Your choices made you richer by an additional 3%. In just a few clicks, you can create and customise your own index on Smallcase. Power lies in your hand, use it wisely.