Fundamental analysis – The January Effect

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Fundamental Analysis

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Fundamental analysis for investors

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The fundamental analysis for investors by raghu palat.


How to make profits in the stock market — steadily and consistently Fundamental analysis is an essential, core skill in an investor’s tool-kit for evaluating a company on the basis of its track record: sales, earnings, dividends, products, management, etc., as well as the economic and industry outlook. It is a value-based approach to stock market investing — solid and prudent — that typically offers handsome profits to the long-term investor. Raghu Palat’s book will help you master the essentials of fundamental analysis. It clearly explains, with examples, all the analytical tools of economic, industry and company analysis, including ratios and cash flow. It shows you how to judge a company’s management and its products, and discover what actually lies behind the figures and notes in a company’s annual report. And, most usefully, how to calculate the intrinsic value of a share. Fundamental analysis will help you base your investment decisions on relevant information, not tips, hunches or assumptions. Doing that will help you make solid, consistent long-term profits. Legendary contemporary investors like Warren Buffett and Peter Lynch used basically this approach to amass fortunes on the stock market. So can you. PRAISE FOR THE BOOK “A priceless primer.” — Business Today “A masterly introduction to fundamental analysis.” — Times of India “Discouraging the use of tips and rumours, Palat introduces the reader to aspects of fundamental analysis so that he can arrive at the intrinsic value of any share and make informed decisions.” — Business India “This book brims with accurate, immediate and relevant examples of Indian companies and our stock market behaviour” — Indian Review of Books “Educates readers” — The Economic Times

ABOUT THE AUTHOR RAGHU PALAT is an acknowledged authority on investment, finance and banking and has written more than thirty extremely well received books on these subjects. A great grandson of His Highness, the late Rama Varma, Maharaja of Cochin and Sir Chettur Sankaran Nair (a member of the Viceroy’s Privy Council and a former President of the Indian National Congress), Raghu Palat is a Fellow of the Institute of Chartered Accountants in England & Wales. A career banker he has held very senior positions with multinational banks in India and abroad. He has worked in Europe, America, Asia and Africa. Raghu Palat is presently a consultant to banks. He also manages a dedicated finance portal called which is a repertoire of rules and regulations relating to finance, commerce, corporates and banks. In addition, he conducts workshops on business etiquette, effective business writing, presentation skills, banking and finance. Mr. Palat has also set up a portal for e-learning The courses are an amalgam of laws, directives and actual real life situations. Raghu Palat lives in Mumbai with his wife Pushpa, two daughters, Divya and Nikhila and their cocker spaniel Champ.

To my mother-in-law Vasanta A. Nair

Disclaimer The author and the publisher disclaim all legal or other responsibilities for any losses which investors may suffer by investing or trading using the methods described in this book. Readers are advised to seek professional guidance before making any specific investments.

ALL RIGHTS RESERVED; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publisher. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published without the prior written consent of the Publisher. A Vision Books Orig inal First eBook Edition, 2020 First Published 1994 , Second Edition, 2000 Third Edition, 2004 , Fourth Edition, 2020 Reprinted 2020, 2020, 2020

eISBN eISBN 10: 81-7094 -94 2-4 eISBN 13: 978-81-7094 -94 2-8 © Raghu Palat, 1994, 2020 Published by Vision Books Pvt. Ltd. (Incorporating Orient Paperbacks and CARING Imprints) 24 Feroze Gandhi Road, Lajpat Nagar 3 New Delhi 110024 , India. Phone: (+91-11) 2984 0821 / 22 e-mail: [email protected]

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Contents About the Book About the Author Preface Acknowledgements Introduction: The Importance of Information 1. Fundamental Analysis: The Search for Intrinsic Value Part One

Economic Analysis 2. Politico-Economic Analysis 3. The Economic Cycle 4. Asset Bubbles: What They Are and How to Protect Yourself When they Burst Part Two

Industry Analysis 5. Industry Analysis Part Three

Company Analysis 6. The Management 7. The Company 8. The Annual Report The Directors’ Report The Auditor’s Report Financial Statements Schedules and Notes to the Accounts

9. Ratios Market Value

Earnings Profitability Liquidity Leverage Debt Service Capacity Asset Management / Efficiency Margins

10. Cash Flow 11. Conclusion 12. Fundamental Analysis Step-by-step Appendix

Preface The Indian capital market is vibrant and alive. Its growth in the last three decades has been phenomenal. In 1983, market capitalization of the shares quoted in the Bombay Stock Exchange amounted to a mere US $7 billion. It grew to US $65 billion in 1992; to US $220 billion by April 2000; to US $ 428 billion in 2003, and hit US $ 1,350 billion (Indian Rs. 60,78,034 crore) in May 2020. Not just that. In May 2020, 4,078 companies were quoted on the Bombay Stock Exchange making it one of the largest such exchange in the world. The ride has been tumultuous. The growth of the market began with the FERA dilution, i.e. when foreign companies were compelled to dilute their holdings in their Indian entities. The interest in the stock market grew with speculators and others entering the arena. Though one may question their methods, individuals such as the late Harshad Mehta must be recognized as people who did much to create an awareness of the market which led India’s middle class to start investing in shares. The reforms following the liberalization of the early 1990s, the entry into this market of foreign institutional investors (FIIs) and mutual funds, coupled with scams and downturns, forced many an individual investor out of the market. The bursting of the dotcom bubble and the Ketan Parekh scam heightened the average investor ’s fears. It is interesting to note that the individual who invested in the market during the boom in the third quarter of 2003 is the young, new generation investor – investors who had not lost monies in the earlier Harshad Mehta or Ketan Parekh scams. Then in the boom of 2006-07, the index soared culminating at 21,078 on 8 January 2008 before falling to below 10,000 within a year in the wake of the world wide economic depression. And, yet, the investor dreams even after he has been mauled. This is because the share market can make one wealthy beyond one’s wildest dreams. With the boom in IT shares, for example, Azim Premji of Wipro was for a brief period the second richest man in the world (after buffetting away Warren Buffett from that position) and Infosys Chairman K. Narayanamurthy was, at one time, worth in excess of Rs. 14,000 crore. During the last two decades, the manner of trading in the markets has changed — from the traditional floor (trading ring) outcry to screen based trading with brokers linked to the major stock exchanges. Shares that are traded in stock exchanges are now dematerialized — making sales / purchases and transfers easy. Payment for shares sold is made within a few days.

Information has exploded. At one time there was an acute dearth. Now it is like a tornado. There are very good reports on companies. There are probing analyses done on performance. There are studied forecasts made. There are intelligent conclusions drawn. The information is there. Any investor can access it. And the investor must access it and, having accessed it, he must, manage the information. In terms of categories of investors, the largest investor segment in the Indian stock market is that of the financial institutions and mutual funds. Foreign institutional investors (FIIs) and Non-Resident Indians (NRIs), too, have a significant presence. By mid-2020, they accounted for about 12% of the investments made in the market. FIIs often impact market movement far beyond their actual share because they can and do move large amounts of money in and out of the market owing to their global perspective. Notwithstanding the considerable institutionalisation of the Indian market is, it is still rumour and insider driven. Even after the many scams, shares continue to be bought on the basis of tips, and for the short term. The average investor does little or no research (even though more information than he can handle is now available) and makes his purchase or sale decision on the strength of an article that he may have read or a conversation with a friend. This is usually because the average investor is unclear on how to analyze companies and is not equipped to arrive at an investment decision. Consequently, he buys and sells with inadequate information and often suffers needless losses. At no time was this more evident than in the first four months of 1992 and later in 2000 when even prices of the “dogs” doubled. It was a period not dissimilar to Wall Street in the mid 1960s which Mr. Harold Q. Masur eloquently described in his book, The Broker: “In the super heated economy of the late sixties there was an illusion of endless prosperity. On Wall Street the bulls were rampant. Private companies were going public at arbitrary prices that generated huge profits for the promoters. Mutual funds were plunging recklessly into new untested issues. Glamour stocks soared to premiums that discounted not only the future but the next millennium. Money, it seemed, was spermatic. Properly invested in the womb of Wall Street, it would produce wildly proliferating offspring. Thousands of new comers opened accounts. Brokerage firms expanded with quixotic optimism.”

As I write this (May 2020), the market is buoyant after two years of being in the doldrums. Experts are prophesying with gay abandon, “The market will grow to 20,000 by Diwali.” Another says, “The market (Sensex) will rise to 30,000 by June 2020.” These are numbers taken out of a hat. They have no logic. They have no credibility. Yet, there are so many gullible investors who, fuelled by greed, buy high and then live to regret having done so. Human nature has not changed.

I’d like you to dwell for a moment on a thought by Harold Masur. He says: “Bargains are available during times of extreme pessimism. Trouble is, when the so-called experts are wringing their hands, nobody has the courage to buy”.

Rothschild echoed this when he said, “Buy when there is blood on the streets.” J. P. Morgan when asked once by an investor on his view of the market is said to have stated: “It will fluctuate.” Some will rise while others will fall. The aim of the investor must be to buy when the price is low and to sell when it is high. Fundamental analysis is not for speculators. It is for those who are prepared to study and analyze a company; for those who arrive at a decision after careful thought and deliberation. Hegel once said, “To those who look upon the world rationally, the world in its turn presents a rational aspect.” Fundamental analysis is for the rational man. This book is for the investor — be he or she an executive, a housewife, a professional, a student or a self-employed person. My aim is to introduce you to the world of information and analysis and to show you how one can arrive at a buy or sell decision. By doing so, I seek to discourage you from acting on rumours or tips and encourage you to go by hard facts. However, the investor must be warned that the world is constantly changing as a consequence of which new situations arise which the investor must continuously monitor. Consequently, there is no fixed formula that will give one “wealth beyond belief”. If such a formula existed, I wouldn’t be writing this book. I would be out there in the market accumulating that wealth. Analysis and information give one the basis for a logical decision. There are other factors, especially the human factor, that are sometimes not logical and cannot be predicted. To select the most promising shares, the investor faces obstacles. The first is in the assessment — the human fallibility factor. The second arises from the nature of competition. The third is from sheer perversity — the failure of the market to be logical. The investor may be wrong in his estimate of the future or even if he is right the current price may already reflect what he is anticipating. The point I am trying to stress is that in the end, the price movements of shares depend on a host of factors. Yet the basic issue remains. The share must have value. Its fundamentals must be good. Its management must be competent. This book will introduce you to the world of fundamental analysis and guide you through the factors that you should look at before you buy any shares. The art of successful investment lies in the choice of those industries that are

most likely to grow in the future and then in identifying the most promising companies in those industries. There are, however, pitfalls in the approach and one must be careful. It must, however, be remembered that: Obvious prospects for physical growth in a business do not translate into obvious profits for investors. Experts do not have dependable ways of concentrating on the most promising companies in the most promising industries. There could also be imbalances on account of political happenings, speculations, demand and a host of other reasons. Further, as Adam Smith said: “Even if, by some magic, you knew the future growth rate of the little darling you just discovered, you do not really know how the market will capitalize that growth. Sometimes the market will pay twenty times earnings for company growing at an annual compounded rate of 30 percent; sometimes it will pay sixty times earnings for the same company. Sometime the market goes on a growth binge, especially when bonds and the more traditional securities do not seem to offer intriguing alternatives. At other times the alternatives are enticing enough to draw away some of the money that goes into pursuing growth. It all depends in the psychological climate of the time.”

That is why he also added: “You can have no preconceived ideas. There are fundamentals in the market place, but the unexplored area is the emotional area. All the charts and breadth indicators and technical players are the statisticians attempts to describe an emotional state.”

This is why finance theory does not support the belief that the fundamental approach, or for that matter any other approach be it technical analysis, random walk, etc. can consistently outperform the market. However, fundamental analysis gives you a fighting chance and it is because of this that I urge you to be familiar with it and practise it when you go out to do battle. I’d like to leave you with an observation made by the then Finance Minister, Mr. Yashwant Sinha on 4 May 2000 after offering certain tax sops at the budget session. He said: “I can appreciate a market responding to fundamentals, but a market which responds to rumours is irresponsible and silly. The BSE (Bombay Stock Exchange) is being driven by rumours, they will have to behave more responsibly.”

Benjamin Graham adds: “The investor’s chief problem is likely to be himself. More money has been made and kept by ordinary people who were temperamentally well suited for the investment process than by those who lacked this quality even though they had extensive knowledge of finance, accounting and stock market lore.”

In summary, the purpose of this book is to help you invest in stocks that have

value; that have good fundamentals. Santayana once said: “Those who do not remember the past are condemned to return to it.” Benjamin Graham added to this by saying, “To invest intelligently in securities one should be forearmed with an adequate knowledge of how the various types of stocks have behaved under varying conditions – some of which one is likely to meet again in one’s experience.” This book attempts to arm you. RAGHU PALAT

Acknowledgements I met Kapil Malhotra of Vision Books in the first quarter of 1993. He met me unannounced and at a time when I was in the midst of a dilemma — the dilemma of whether I should write another book on accounting and pure finance. It was he who suggested, after listening very patiently, that I should consider, not a book on pure finance but on fundamental analysis. I confess that this was a thought I had not considered and the more I thought of it, the more it made sense. I must therefore thank Kapil for the idea and constant encouragement and it is because of him that this book has been written. Nobody, other than a professional writer, can have the time to devote to writing after a full working day, unless practically all his responsibilities are borne by another. My wife Pushpa is wonderful. She works as I do and she has practically singlehandedly brought up both our children, Divya and Nikhila, beautifully. She sits with them in the evenings, helping them with their homework thereby giving me the time and space to write. Without her love, support and encouragement, I would not have been able to write a single line — let alone numerous books. I am indeed fortunate in having such a wife. I must thank the other members of my family too — my daughters Divya and Nikhila, my brother Ravi, my father-in-law, K. V. A. Nair, and my mother-inlaw, Vasanta Nair. One of my father-in-law’s greatest dreams — and the greatest challenge of his life — has been to interest my mother-in-law in the fascinating world of shares. Alas and alack he struggles on — the end is not in sight as yet. I dedicate this book to that charming lady, my mother-in-law Vasanta Nair in the hope that she will read this book from cover to cover and become fascinated by shares. Thus, my father-in-law’s dream will be realised.

Introduction The Importance of Information “The market,” says Mr. Johnson in Adam Smith’s The Money Game, “is like a beautiful woman — endlessly fascinating, endlessly complex, always changing, always mystifying. I have been absorbed and immersed since 1924 and I know this is no science. It is an art. Now we have computers and all sorts of statistics but the market is still the same and understanding the market is still no easier. It is personal intuition, sensing patterns of behaviour. There is always something unknown, undiscerned.” The market is fascinating and addictive and once you have entered it “it is foolish to think that you can withdraw from the exchange after you have tasted the sweetness of the honey”, De La Vega commented in the seventeenth century. The lure of the market is the promise of great wealth. Warren Buffett has been for several years one of the wealthiest men in the world. His net worth was estimated by Forbes in 2020 to be $ 47 billion. The wealth is entirely from the market — by managing an investing company called Hathaway. He believes in value investing — in fundamental analysis. It is the promise of great wealth, of emulating persons like Buffett and his gurus Benjamin Graham and Bernard Baruch that spurs investors on. This lure was demonstrated in India in 1992, at the end of the millennium (in the first 4 months of 2000), from the end of the second quarter of 2003, and more recently in 2006 and 2007 when prices soared. The manner in which these speculative drives occur are similar and happens with amazing frequency and regularity. This is not restricted to shares either. The tulip mania in Holland in the seventeenth century sent their prices soaring. In 1992, the rush to buy shares in India was so great that ancestral land and family jewels were sold or pawned in the overpowering, overwhelming greed for riches. For a time, prices rose and then the bubble burst. This occurred again in early 2000 when information technology share prices rose to phenomenal heights. Many shrewd promoters changed the names of their companies to “infotech”, or added the word “infotech” to its name and made a killing in the market. The law of gravity has to prevail and their prices fell dramatically in March and April 2000, supporting the truth that prices of companies will fall or rise to their true level in time. The prices of shares rose as the crowd had taken over and there was no place then for logic or good

sense. As Gustave Le Bon observed in his Psychologic des Toules, the crowd acts with a single-minded purpose and not very rationally. According to him, the most striking peculiarity of a crowd is that “whoever be the individuals that compose it, however like or unlike be their mode of life, their occupations, their character of their intelligence, the fact that they have been transformed into a crowd puts them in possession of a sort of collective mind which makes them feel, think, and act in a manner different from that in which each individual of them would feel, think, and act were he in a state of isolation”. Le Bon speaks of the crowd being in a state of hypnotized fascination and the rational investor becoming mindless in the sense that he surrenders his rational thinking mind to the dominant mood of the moment. The crowd in late 1999 and early 2000 everywhere, and in India in 1992 and again in 2006 and 2007, acted on impulse, on expectations and hope and on hearsay fuelled by greed. The index bloated like a balloon and like a balloon it burst. It had to. Unfortunately at times such as these the ones that lose are the small investors who do not have their eye on the market at all times, nor do they have the contacts or wherewithal to know what is likely to happen to the market. Let us examine what happened in the last two decades in India. In 1992, investors were buying on the flimsiest of reasons believing there was no end to the boom. I remember a person advising me to buy the shares of a certain company. This was at the time not a very well known company. I asked him for some information — what did the company do? Who were its directors? How had it performed in the last three years? He did not know, nor did he care. He had received a tip that the price would double and was passing it on. Another share that must be mentioned was Karnataka Ball Bearings — a company whose share was languishing in the low 20s. Sparked by a rumour that Harshad Mehta was buying the share, its price rose to Rs. 60, then to Rs. 68 and went all the way up to Rs. 180, all in matter of just ten days. It was then heard that the rumour about Harshad Mehta’s interest in the share was false. The share price plunged to Rs. 50 in four days. The original rumour raised its head. The price rose again to Rs. 120. The rumour was again condemned as false and the price fell. At that time I spoke with a person intimately connected with the company. He told me that the company was sick and that there was no business activity. In fact, it was on the verge of closing down. The price had risen on the flimsiest of excuses and the crowd comprising of otherwise intelligent, logical and rational human beings, acted irrationally and illogically. A lot of persons did make money on the stock — but most lost, having bought it with no other information than the rumour that Harshad Mehta was buying the share. One would have thought one learns. Not so.

History repeats itself. At the end of the last century Indian shares, especially those related to Information Technology (IT), such as Wipro, Infosys (lovingly called Infy) and Satyam (Sify) began to be quoted in America in the NASDAQ. With the rise in NASDAQ, these shares began rising and a wave feeling took over that software was the new mantra and that the shares of all IT companies could only go one way — up. Thus began an upward movement that gained momentum every day till prices became unreal. The wise began to exit and as this took root prices began to fall. This had a snowballing effect and soon prices had fallen by more than 50%. Then, later, when the dotcom boom occurred, shares were priced on the basis of “stickiness of eyeballs”. It is impossible to get more esoteric. Later in 2000 people began buying shares that Ketan Parekh was purportedly buying. The question that begs an answer is, “Will investors never learn?” The answer probably is that man’s greed is bottomless. In 2003, prices again began moving upwards. The Sensex broke through the 5,000 barrier and there were many who predicted that it would reach 6,000 in six months/ one year/ very soon. In 2006 and 2007 there was an unprecedented surge in the Sensex. It culminated on 8 January 2008 when the Sensex closed at 21,078. At that time it was predicted the Sensex would cross 50,000 within a few months. Many buy on the “strength” of these predictions which are nothing but predictions, hopes, expectations. Nothing backed by logic or sense. Fundamental analysis submits that no one should purchase a share on a whim. Investment in shares is serious business and all aspects and factors, however minor, must be analyzed and considered. The billionaire Jean Paul Getty, until his death the richest man in the world, once said, “No one should buy (a share) without knowing as much as possible about the company that issues it”. Jim Slater was one of the most successful stock pickers of all time. He evolved a theory called the Zulu theory which submits that one must know all about the company and the industry, and any other factor that may affect the company’s performance. His argument was that one could never lose if one has this information. If the company is likely to do badly, one can sell and then buy shares to cover this when the price falls, and vice versa. This is the philosophy of professional and successful investors — informed investing. And this is the foremost tenet of fundamental analysis. As Adam Smith says, “There is no substitute for information. The market is not a roulette wheel. Good research and good ideas are the one absolute necessity in the market place.” Fundamental analysis demands, nay insists, on solid information about a company. It requires subjecting a company’s performance and its financial statements to the most piercing scrutiny as well as the analysis of the economy

and the industry in which the company operates. The fundamentalist then makes his buy or sell decision on the basis of his interpretation of the information that he receives, his analysis, and on the strength of his experience and investment maturity. All information is important and can be grouped under the following classifications: 1. 2. 3. 4.

Information about the economy. Information about government policy; taxation, levies, duties and others. Information about the industry in which the company operates. Information about the company — its management, its performance, its sales and its products including its performance in relation to other similar companies. 5. Information about consumer outlook, fashions and spending. In India, we are fortunate that there is greater awareness of the need for information today than ever before and this need is being addressed by the media, researchers and professional investment consultants.

Internet The internet is a tremendous source of information. It can tell you about the economy, company results, profiles and a host of other information. Now can even buy and sell shares instantly on the Net.

Media There are several investment and business focused magazines, newspapers and directories available today that discuss the economy, industries and individual companies. These contain articles of a high standard that analyze industries and companies in depth. They also contain knowledgeable articles on tax, investment strategies, finance and allied subjects. I would insist that the serious investor should read at least one good financial paper every day and two magazines a month. This ought to keep him well informed.

Investment Newsletters There are several professional investment managers and experts who publish investment information. This is extremely useful as they are often very up-todate and contain information not generally available to the investor.

Insiders Insiders are persons who work for a company or who have intimate dealings with a company and have access to, or are aware of, information that is not generally known. This could be information on the performance of the company, upcoming rights or bonus issues, or some other relevant news. As the information is not known to all, the investor must act fast if he wishes to make a killing. The Securities Exchange Board of India (SEBI) has published regulations prohibiting insider trading. I would also caution against insider trading; apart from the fact that it is against SEBI rules and the law, it is fraught with other risks. Edwin Leferre, in his book, Reminiscences of a Stockbroker also warned against it saying, “Wall Street professionals know that acting on inside tips will break a man more quickly than famine, pestilence, crop failure, political readjustments or what may be called normal accidents.”

Seminars and Lectures by Investment Experts Excellent seminars and lectures are being held in the country. These are conducted by eminent individuals and one can pick up a lot of information by attending these lectures. These may be on how an industry is doing, their view of an industry, and the like. One can even share thoughts with those they meet. This can result in forming opinions. Acting on these opinions could be profitable.

Stockbrokers Stockbrokers are always in touch with companies and are normally aware of their performance and other factors affecting the price of a share. However, it should be remembered that: Stockbrokers usually view companies from a short term point of view. A lot of information that a broker gives is based on rumours and tips — many of which may be untrue and unsubstantiated. Stockbrokers sometimes describe companies glowingly based on hearsay; this could be misleading. Brokers may also give you information to make you buy the shares they want to offload. These are the major sources of information. You must train yourself to listen and absorb information that you receive. You should analyze and interpret the information to determine the profitable course of action to be taken. This is the essential governing principle of fundamental analysis — action only after receiving and analyzing information. It is also extremely important that one acts swiftly on the information received as the person who receives it first will often be the person to profit most from it. That is what Rothschild did. 18 June 1815, was a date that will be remembered as the day when one of the most decisive battles in Europe was fought — the day the Duke of Wellington pitted his 75,000 English troops against the 100,000 soldiers of Napoleon. The battle was momentous as the future of Europe and the European colonies around the world rested on its outcome. Investors in London were concerned and worried. As the German army under Marshal Von Blucher had not joined its English ally at the time the battle began, there was concern that England would lose the battle. The British East India Company’s trade with India and China was threatened. There was fear that its allies might desert England. The future of the English Empire was at stake. Investors awaited news. Nathan Rothschild of the House of Rothschild, a leading merchant banker, aware of the importance of information, had invested a considerable sum to develop a private intelligence system. This was well known. It was also well known that Rothschild had invested heavily on an English victory. As soon as the war was over, Rothschild’s agents dispatched to

him carrier pigeons with the result of the war in code. When they arrived, well before the official dispatches, Rothschild began to sell every thing he owned. In the belief that the English had lost, investors panicked and began to sell. The market collapsed. In the depressed market, Rothschild stepped in and, along with his agents bought and bought. Within hours, the news of Wellington’s victory sent the market booming. By this manoeuvre, Rothschild earned one million pounds, a fabulous amount at that time and it is this that led him to state, “The best time to buy is when blood is running in the streets”.

Fundamental Analysis The Search for Intrinsic Value Fundamental analysis is based on the premise that every share has a certain intrinsic value at a period of time. This intrinsic value changes from time to time as a consequence of both internal and external factors. The theory of fundamental analysis submits that one should purchase a share when it is available below its intrinsic value and sell it when it rises above its intrinsic value. When the market value of a share is below its intrinsic value it is under valued, whereas if the market value of a share is above its intrinsic value it is over valued. Fundamentalists thus seek to purchase underpriced shares and sell overpriced ones. They believe that although the market price may deviate from the intrinsic value in the short term, in the long term the market price will be equal to the intrinsic value.

What is Intrinsic Value What is the intrinsic value of a share? How is it determined? Fundamental analysis propounds that the intrinsic value is, and has to be, based on the benefits that accrue to investors in the share. As the return to shareholders is in the form of dividends, under strict fundamental analysis, the present value of future dividends discounted on the basis of its perceived safety or risk is its intrinsic value. The intrinsic value is based on the dividend because that is what a shareholder or investor receives from a company, and not on the earnings per share of the company. This distinction is very important.

Calculation of Intrinsic Value How, then, does one calculate the intrinsic value of a share? Let us assume that one expects a return of 20% on an investment every year for 3 years. Let us also assume that the company would pay dividends of 20%, 25% and 30% on its Rs. 10 share. The dividend received on a share would therefore be Rs. 2.00 in the first year, Rs. 2.50 in the second, and Rs. 3.00 in the third. Let us also assume that the share can be sold at Rs. 200 at the end of 3 years. The intrinsic value of the share will be:

The logic is to discount the dividend received and anticipated to be received in future years and the expected price at a future date with the return or yield expected. Since the price at that future date is also considered, the possibility of capital appreciation is considered and this is why this method of arriving at the intrinsic value is considered the most balanced and fair. If the market price of the share is below Rs. 120.88 then the share is below its intrinsic value and therefore well worth purchasing. If, on the other hand, the market price is higher, it is a sell signal and the share should be sold.

Considerations It must be noted that the intrinsic value of a share can and will be different for different individuals. If, in regard to the above mentioned investment another individual (Kumar) expects a return of 16% whereas a third individual (Nair) expects a return of 25%, the intrinsic value (assuming the dividends and the sale value at the end of 3 years will remain the same will be) — Intrinsic value for Kumar:

Intrinsic value for Nair:

Thus if the market price is Rs. 120.88, the first individual (let us call him Siddharth) will hold onto the share whereas Nair would sell the share and Kumar would purchase it. In short, the intrinsic value of a share will vary from individual to individual and will be dependant both on that individual’s ability to bear risks and the return that individual expects. It is prudent and logical to remove this anomaly. The return expected should be the return one can expect from an alternate, reasonably safe investment in that market. This rate should be bolstered by a risk factor as the return is greater from riskier investments. A very safe investment (blue chip) will have a risk rate of 0. A mature near blue chip share will have a risk rate of 1. A growing company will have a risk rate of 2. A risky new company will have a risk rate of 3. If it is assumed that the return one can expect from a reasonably safe investment (an investment say with the Unit Trust of India) is 16%, and the dividend expected is Rs. 2 in the first year, Rs. 2.5 in the second year and Rs. 3 in the third year and the anticipated sale price is expected to be Rs. 200, the intrinsic value of the share of the company will be as follows depending on its financial strength and stage of growth:

It would be noted that the safer the share, the higher its intrinsic value. There is however one factor that is assumed or estimated and that is the price at the end of three years. The most reasonable method (even though this is arguable), in my opinion is basing the price on a price earnings multiple. The price earnings multiple or P/E of a share is its market price divided by its earnings per share. If a company has earned Rs. 7 per share in the current year representing a growth of 20% and if it is conservatively believed that the earnings per share (EPS) will grow 15% every year: EPS at the end of: Year 1 will be Rs. 7.70 EPS at the end of: Year 2 will be Rs. 8.47 EPS at the end of: Year 3 will be Rs. 9.32. If it is believed that a reasonable P/E for a company of such a size in that industry should be 15, the market price at the end of 3 years would be 9.32 × 15 = Rs. 139.80. Let us now look at a real example. On 31 May 2020 the price of the shares of a company was Rs. 465. The company declared a dividend of 65% for the year ended 31 March 2020 and an earnings per share of Rs. 13.3. If we assume that this dividend will remain constant, and that a P/E of 20 is reasonable, the intrinsic value of the company’s share should be Rs. 266. If the company’s earnings grow at 20% per year the EPS at the end of 3 years would be Rs. 22.98 (13.3 x 1.20 x 1.20 x 1.20). On that assumption, the price at the end of 3 years would be Rs. 459.60 (EPS × P/E of 20). Based on an expected return of 20%, the intrinsic value today will therefore be:

The company’s share price at Rs. 465 was thus nearly 67% above its intrinsic value and on the basis of this submission should be sold. The price of a 100% export oriented unit on 31 May 2020 was 160. Its profit in the year to 31 March 2020 had grown by 60% to Rs. 17.88 crore. Its earnings per share at Rs. 10.26 was an improvement of 23%. If we assume that in the next 2 years its EPs will grow by 20%, the EPS at the end of 2 years would be Rs. 14.77. At a P/E of 15, its market price at the end of 2 years would be Rs. 221.55. In 2020, the company paid a dividend of 25%. On the assumption that the dividend of 25% will be maintained in 2020, and that it will rise to 30% in 2005, its intrinsic value on an expected return of 20% would be:

Its intrinsic value of Rs. 158.02 was very close to the market value of Rs. 160. If however, one expects a return of 25% as that export oriented unit is a relatively new company, the intrinsic value would be:

At an expected return of 25%, the market value of Rs. 160 was higher than the intrinsic value of Rs. 145.71 and the share should be sold. The subjective assumptions made in arriving at the intrinsic value results in the intrinsic value of a share being different for different individuals. In the example detailed above, the intrinsic value of that company share would be Rs. 158.02 for an investor who expects a return of 20%, whereas it would be Rs. 145.71 for an individual expecting a return of 25%. The other assumptions too are subjective, i.e. the expected price at the end of a period, and the anticipated dividends during the period. This method, however, is extremely logical. It considers the dividends that will be paid and the likely capital appreciation that will take place.

Efficient Market Theory Fundamental analysts often use the efficient market theory in determining the intrinsic price of a share. This theory submits that in an efficient market all investors receive information instantly and that it is understood and analyzed by all the market players and is immediately reflected in the market prices. The market price, therefore, at every point in time represents the latest position at all times. The efficient market theory submits it is not possible to make profits looking at old data or by studying the patterns of previous price changes. It assumes that all foreseeable events have already been built into the current market price. Thus, to work out the likely future price at a future date in order to determine the share’s present intrinsic value, fundamentalists devote time and effort to ascertain the effect of various happenings (present and future) on the profitability of the company and its likely results. This must also include the possibility of the company issuing bonus shares or offering rights shares. The most important factor in fundamental analysis is information — information about the economy, the industry and the company itself — any information that can affect the growth and profitability of the company and it is because of this fundamental analysis is broken into three distinct parts: 1. The economy, 2. The industry within which the company operates, and 3. The company. The information has to be interpreted and analyzed and the intrinsic value of the share determined. This intrinsic value must, then, be compared against the market value the fundamentalists say, and only then can an investment decision be taken.

Politico-Economic Analysis A wise man once said, “No man is an island.” No person can work and live in isolation. External forces are constantly influencing an individual’s actions and affecting him. Similarly, no industry or company can exist in isolation. It may have splendid managers and a tremendous product. However, its sales and its costs are affected by factors, some of which are beyond its control — the world economy, price inflation, taxes and a host of others. It is important, therefore, to have an appreciation of the politico-economic factors that affect an industry and a company.

The Political Equation A stable political environment is necessary for steady, balanced growth. If a country is ruled by a stable government which takes decisions for the longterm development of the country, industry and companies will prosper. On the other hand, instability causes insecurity, especially if there is the possibility of a government being ousted and replaced by another that holds diametrically different political and economic beliefs. India has gone through a fairly difficult period. There had been terrible political instability after the ouster of Mr. Narasimha Rao from the Prime Ministership. Successive elections held did not give any single political party a clear majority and mandate. As a result there were coalitions of unlikes. These led to considerable jockeying for power and led to the breakup of the governments and fresh elections. There has also been much grand standing such as the Mandal recommendations in order to capture votes. These led to riots. There were other religious and ethnic issues that also led to violence such as the Babri Masjid/Ram Janmabhoomi issue. There were Hindu-Muslim disturbances and bomb blasts. All these shook the confidence of the developed world in the security and stability of India. Tourism fell. Foreign Direct Investment fell. Investments were held back. These had an adverse impact on the development of the economy. In recent times this scenario has changed. The Government, even though a coalition one has been stable. Its policies have been positive and the economy has been doing well. There are predictions that by 2050, India would be one of the three most powerful nations in the world. This has led to renewed interest in India and investors are back. International events too impact industries and companies. The USSR was one of India’s biggest purchasers. When that enormous country broke up into the Confederation of Independent States, Indian exports declined and this affected the profitability of companies who had to search for other markets. Wars have a similar effect. The war in Croatia, in Kosovo, in Africa, the Gulf war and other wars have had an effect on exports of goods. The tragedy of 9/11 (September 9 when two planes crashed into the World Trade Center at New York), affected the entire world. Many industries are yet to fully recover. Similarly the SARS epidemic that affected South East Asia affected trade and tourism. The other gnawing political issue that is a thorn in India’s back is the Pakistan issue. The deterioration in our relationship culminated in 1999 in the

war in Kargil. Earlier we have fought several wars on Kashmir and other issues. Wars push up inflation and demand declines. It is estimated that the Gulf War cost India $1.5 billion on account of higher prices of petroleum products, opportunity costs and fall in exports. The defence budget is enormous. This money could have been spent elsewhere for the development of the country. Other examples include Sri Lanka, East Europe and other troubled countries. These countries were once thriving. No longer. Let us take the example of Sri Lanka. It is a beautiful island and was considered a paradise for tourists — a pearl in the ocean. The country is in the grips of a civil war. The northern part of the country, which was once thriving, is in the hands of Tamil guerillas and there is no industry and little economic activity. Idi Amin in the seventies by expelling Asians from Uganda did that country’s economy irreparable harm. In 1997-98, due to the elections and then the bombing of the American embassy, the economy of Kenya tailspinned to negative growth. Then a few years later as the economy was recovering, the Mombasa bombings again set it back. In conclusion, the political stability of a country is of paramount importance. No industry or company can grow and prosper in the midst of political turmoil.

Foreign Exchange Reserves A country needs foreign exchange reserves to meet its commitments, pay for its imports and service foreign debts. Without foreign exchange, a country would not be able to import materials or goods for its development and there is also a loss of international confidence in such a country. In 1991, India was forced to devalue the rupee as our foreign exchange reserves were, at $532 million very low, barely enough for few weeks’ imports. The crisis was averted at that time by an IMF loan, the pledging of gold, and the devaluation of the rupee. Several North American banks had to write off large loans advanced to South American countries when these countries were unable to make repayments. Certain African countries too have very low foreign exchange reserves. Companies exporting to such countries have to be careful as the importing companies may not be able to pay for their purchases because the country does not have adequate foreign exchange. I know of an Indian company which had exported machines to an African company a few years ago. The importing company paid the money to its bank. It lies there still. The payment could not be sent to India as the central bank refused the foreign exchange to make the payment. Following the liberalization moves initiated by the Narasimha Rao Government and endorsed/supported by successive governments, India had by 31 December 1999 foreign investments in excess of $28 billion. In May 2000, the foreign exchange reserves had swelled to over $38.4 billion — a far cry from the $500 million of reserves in 1991. In 2003, the reserves are in excess of $100 billion. The problem the Reserve Bank of India now faces is managing the huge reserves. In order to discourage short term flows, the Reserve Bank has lowered interest rates and even mandated that the interest paid should not exceed 25 basis points.

Foreign Exchange Risk This is a real risk and one must be cognizant of the effect of a revaluation or devaluation of the currency either in the home country or in the country the company deals in. A devaluation in the home country would make the company’s products more attractive in other countries. It would also make imports more expensive and if a company is dependent on imports, margins can get reduced. On the other hand, a devaluation in the country to which one exports would make the company’s products more expensive and this can adversely impact sales. A method by which foreign exchange risks can be hedged is by entering into forward contracts, i.e. advance purchase or sale of foreign exchange thereby crystallizing the exposure. In India our currency has been appreciating against the dollar. Thus, the threat investors or recipients of dollars face is that the rupees that they finally receive is less than that they expected. This is an about turn from the situation earlier. As a consequence many have begun quoting in rupees.

Restrictive Practices Restrictive practices or cartels imposed by countries can affect companies and industries. The United States of America has restrictions regarding the imports of a variety of articles such as textiles. Licenses are given and amounts that may be imported from companies and countries are clearly detailed. Similarly, India has a number of restrictions on what may be imported and at what rate of duty. To an extent this determines the prices at which goods can be sold. If the domestic industry is to be supported, the duties levied may be increased resulting in imports becoming unattractive. During the last two years Indian customs duties have been reduced drastically. Imports are consequently much cheaper and this has affected several industries. When viewing a company, it is important to see how sensitive it is to governmental policies and restrictive practices.

Foreign Debt and the Balance of Trade Foreign debt, especially if it is very large, can be a tremendous burden on an economy. India pays around $ 5 billion a year in principal repayments and interest payments. This is no small sum. This has been the price the country has had to pay due to our imports being far in excess of exports and an adverse balance of payments. At the time the country did borrow, it had no alternative. In 1991, at the time of devaluation, India had only enough foreign exchange to finance the imports of few weeks. It is to reverse this that the government did borrow from the World Bank and devalue the currency. A permanent solution will result only when the inflow of foreign currency exceeds the outflow and it is on account of this that tourism, exports and exchange earning/saving industries are encouraged.

Inflation Inflation has an enormous effect in the economy. Within the country it erodes purchasing power. As a consequence, demand falls. If the rate of inflation in the country from which a company imports is high then the cost of production in that country will automatically go up. This might reduce the cost competitiveness of the product finally manufactured. Conversely, if the rate of inflation in the country to which one exports is high, the products become more attractive resulting in increased sales. The USA and Europe have fairly low inflation rates (about 5%). In India, inflation has been falling steadily in recent times. It is currently estimated at between 2.5% and 3%. In South America, at one time, it was over 1000%. Money there had no real value. Ironically, South American exports become attractive on account of galloping inflation and the consequent devaluation of their currency which makes their products cheaper in the international markets. Low inflation within a country indicates stability and domestic companies and industries prosper at such times.

The Threat of Nationalization The threat of nationalization is a real threat in many countries — the fear that a company may become nationalized. With very few exceptions, nationalized companies are historically less efficient than their private sector counterparts. If one is dependent on a company for certain supplies, nationalization could result in supplies becoming erratic. In addition, the fear of nationalization chokes private investment and there could be a flight of capital to other countries.

Interest Rates A low interest rate stimulates investment and industry. Conversely, high interest rates result in higher cost of production and lower consumption. When the cost of money is high, a company’s competitiveness decreases. In India, the Government has embarked on a drive to have interest rates reduced. This is successful. The interest savings of many companies are significant.

Taxation The level of taxation in a country has a direct effect on the economy. If tax rates are low, people have more disposable income. In addition they have an incentive to work harder and earn more. And an incentive to invest. This is good for the economy. It is interesting to note that in every economy there is a level between 35% to 55% where tax collection will be the highest. While the tax rates may go up, collection will decline. This is why there it has been argued that the rates in India must be lowered.

Government Policy Government policy has a direct impact on the economy. A government that is perceived to be pro-industry will attract investment. The liberalization policies of the Narsimha Rao government excited the developed world and foreign companies grew keen to invest in India and increase their existing stakes in their Indian ventures. The move to build and improve infrastructure of the BJP government is creating renewed interest.

Domestic Savings and Its Utilization If utilized productively, domestic savings can accelerate economic growth. India has one of the largest rate of savings (22%). In USA, it is only 2% whereas in Japan it is as high as 23%. Japan’s growth was on account of its domestic savings invested profitably and efficiently. Although India’s savings are high, these savings have not been invested either wisely or well. Consequently, there has been little growth. It is to be remembered that all investments are born out of savings. Borrowed funds invested have to be returned. Investments from savings leads to greater consumption in the future. This has been recognized by the Government and it was in order to divert savings to industry the 1992 Finance Act stipulated that productive assets of individuals (shares, debentures, etc.) would not be liable for wealth tax.

The Infrastructure The development of an economy is dependent on its infrastructure. Industry needs electricity to manufacture and roads to transport goods. Bad infrastructure leads to inefficiencies, poor productivity, wastage and delays. This is possibly the reason why the 1993 budget lay so much emphasis, and offered so many benefits, to infrastructural industries, such as power and transportation. In recent years there has been greater emphasis. Flyovers have been built, national highways are being widened and made better and the improvement made in communications is awesome.

Budgetary Deficit A budgetary deficit occurs when governmental expenditure exceeds its income. Expenditure stimulates the economy by creating jobs and stimulating demand. However, this can also lead to deficit financing and inflation. Both these, if not checked, can result in spiralling prices. To control and cut deficits governments normally cut governmental expenditure. This would also result in a fall in money supply and a consequent fall in demand which will check inflation. All developing economies suffer from budget deficits as governments spend to improve the infrastructure — build roads, power stations and the like. India is no exception. Budget deficits have been high. The government has, to reduce inflation consciously cut expenditure down and it has reduced from a high of around 15% few years ago to 6% -7% today.

Monsoons The Indian economy is an agrarian one and it is therefore extremely dependent on the monsoon. Economic activity often comes to a stand still in late March and early April as people wait to see whether the monsoon is likely to be good or not.

Employment High employment is required to achieve a good growth in national income. As the population growth is faster than the economic growth unemployment is increasing. This is not good for the economy.

The Economic Cycle Countries go through the business or economic cycle and the stage of the cycle at which a country is in has a direct impact both on industry and individual companies. It affects investment decisions, employment, demand and the profitability of companies. While some industries such as shipping or consumer durable goods are greatly affected by the business cycle, others such as the food or health industry are not affected to the same extent. This is because in regard to certain products consumers can postpone their purchase decisions, whereas in certain others they cannot.

The four stages of an economic cycle are: Depression Recovery Boom Recession.

Depression At the time of depression, demand is low and falling. Inflation is often high and so are interest rates. Companies, crippled by high borrowing and falling sales, are forced to curtail production, close down plants built at times of higher demand, and let workers go. The United States went through a depression in the late seventies. The economy recovered and the eighties was a period of boom. Another downturn occurred in the late eighties and early nineties, especially after the Gulf War. The recovery of the US economy and that of the rest of Western Europe began again in 1993. Later the US again went through a period of depression at the turn of the millennium. India too went through a difficult period and it began its recovery in 2002.

Recovery During this phase, the economy begins to recover. Investment begins anew and the demand grows. Companies begin to post profits. Conspicuous spending begins once again. Once the recovery stage sets in fully, profits begin to grow at a higher proportionate rate. More and more new companies are floated to meet the increasing demand in the economy. In India 2003 could be seen as a year of recovery. All the attributes of a recovery are evident in the economy.

Boom At the boom phase, demand reaches an all time high. Investment is also high. Interest rates are low. Gradually as time goes on, supply begins to exceed the demand. Prices that had been rising begin to fall. Inflation begins to increase.

Recession The economy slowly begins to downturn. Demand starts falling. Interest rates and inflation begin to increase. Companies start finding it difficult to sell their goods. The economy slowly begins to downturn. Demand starts falling. Interest rates and inflation begin to increase. Companies start finding it difficult to sell their goods. India went through a terrible recession for 4 years from 1996.

The Investment Decision Investors should attempt to determine the stage of the economic cycle the country is in. They should invest at the end of a depression when the economy begins to recover, and at the end of a recession. Investors should disinvest either just before or during the boom, or, at the worst, just after the boom. Investment and disinvestment made at these times will earn the investor the greatest benefits. It must however be noted that there is no rule or law that states that a recession would last a certain number of years, or that a boom would be for a definite period of time. Hence the length of previous cycles should not be used as a measure to forecast the length of an existing cycle. An investor should also be aware that government policy or other events can reverse a stage and it is therefore imperative that investors analyze the impact of government and political decisions on the economy before making the final investment decision. Joseph Schumpeter once said, “Cycles are not, like tonsils, separable things that might be treated by themselves but are, like the beat of the heart, of the essence of organism that displays them.”

Asset Bubbles What They Are and How to Protect Yourself When they Burst An asset bubble occurs when the prices of assets are overinflated due to an excess of demand. It occurs when there is a lot of money in the system, interest rates are relatively low, credit is easy, unemployment is low. It occurs at a time when economic confidence is high. Asset bubbles can affect many assets, including commodities, real estate and stocks. At the time of a bubble, there is usually euphoria and a widespread sense of excitement. Price rises are justified by reasoning and the expectation of further increases in price. After several years of a depressed market, prices begin to rise in the wake of an economic boom. Such a relentless price rise was witnessed in the Indian stock markets through 2006 and 2007, finally culminating on 8 January 2008 when the Bombay Stock Exchange Sensitivity Index (Sensex) soared to a high of 21,078. At the time, the euphoria was so great that there were predictions that the Sensex would soar to 50,000 by June 2008. Real estate prices, too, rose in tandem. Credit was easy. Interest rates were relatively low. There was jubilation in the air. Bubbles burst. When the euphoria becomes unsustainable a crash is inevitable. In the third week of January 2008, the Sensex witnessed great falls. On 21 January 2008, the Sensex fell by 1,408 points. Later, it went into a free fall, falling month on month to close below 9,000 in November 2008. Other assets too fell in sync as demand petered out in the face of an economic depression. There was a similar burst of an asset bubble after the Harshad Mehta scam in 1992-93 and in 2001-2002. In stock markets, an asset bubble is an extended period of extreme overvaluation. Bubbles occur when there is excessive speculation. As opposed to viewing the intrinsic value of a share (based on fundamental analysis), speculators focus on its resale value. An asset is bought in the expectation that it would double or triple in a relatively short time. Rumours fly. Examples are cited of investors who have made huge killings. Economic data and sensible thought are abandoned for greed. Herd mentality takes over and the mass follow the leader — the bull — without thought or reasoning. In bubbles, it is of no consequence that the price is irrationally high. It only matters that it can

be sold for an even higher irrational price at a later date. As happened to the Sensex, bubbles end with steep declines, where most of the speculative gains are quickly wiped out. The problem is that it is hard to tell a bubble until it bursts. When central or other regulatory bodies intervene, it brings about what it was intended to prevent — a free fall. There are two types of bubbles. The first type of asset bubble is created by banks or brokerage houses. They pump up the price of an asset. The assets can be shares, currencies or other financial instruments. In the second type of bubble, avaricious and susceptible investors are lured into investment swindles by the promise of impossibly high profits and interest payments. In India, the late 1980s and early 1990s witnessed many initial public offerings (IPOs) of investment and other companies which hinted at huge returns and ensnared gullible investors. When a bubble lasts, a whole host of pundits, analysts and schools try and justify it. I recollect during the Harshad Mehta led boom, pundits justifying it by stating Indian stocks were greatly undervalued and that they had nowhere to go but up. During the boom of 2006-2007, the bubble was justified by saying that the potential of Indian companies was unimaginable — India is the glowing star and the economy is going to grow even faster, went the refrain. People even argued that the new and vibrant economy was exempt from “old rules and archaic modes of thinking”. They insisted that productivity had surged and established a steeper but sustainable, trend line. I remember an argument with regard to the valuation of ACC in the early 1990s. The gurus argued that the company should not be valued on the basis of its fundamentals but on what it would cost to build a similar company. The trouble is that these learned people sound authoritative and so sure of themselves that individual investors believe them. As a fundamental investor, you must be wary of such “This time it’s different” arguments. If you cannot understand the reason for the rise in the prices of stocks; if the reason for growth is speculative; if everyone including your maids and taxi drivers are talking of shares, then it would be wise to sell your holdings. I remember in late 2007, a friend wondering when the boom would end and another replying that it would not happen in the foreseeable future. He said it so forcefully that a couple of others sought tips from this individual and bought shares. To their horror, these shares fell by 300% within six months. Also, you must not get carried away by television interviews and newspaper reports. You should remember that these authorities are usually as

clueless as you are. If they could actually see the future so clearly, would they be sharing their knowledge with you? They’d be out there making a killing by either selling or buying shares. They are not humanitarians who’d want you to grow wealthy with them. Claud Cockburn, writing for the Times of London from New York described the irrational exuberance that gripped the United States prior to the Great Depression. He wrote: “The atmosphere of the great boom was savagely exciting, but there were times when a person with my European background felt alarmingly lonely. He would have liked to believe, as these people believed, in the eternal upswing of the big bull market or else to meet just one person with whom he might discuss some general doubts without being regarded as an imbecile or a person of deliberately evil intent — some kind of anarchist, perhaps.” The greatest analysts with the most impeccable credentials and track records failed to predict the crash and the unprecedented economic depression that followed it. Newspapers even misled people. On Black Monday (24 October 1929) when the market collapsed The New York Times wrote, “Rally at close cheers brokers, bankers optimistic.” Nearer home even our media continues making comments such as this. Robert Barsky and Bradford De Long wrote in an article entitled “Bull and Bear Markets in the Twentieth Century”: “Major bull and bear markets were driven by shifts in assessments of fundamentals; investors had little knowledge of crucial factors, in particular the long run dividend growth rate and their changing expectations of average growth plausibly lie behind the major swings of this century.” I agree with this view. Investments made on hearsay as opposed to those made on the basis of fundamental analysis are doomed from the start. It is shortsighted to buy a share whose intrinsic value is Rs. 30 at Rs. 250 on the expectation that it would grow to Rs. 500 in a year’s time. Its intrinsic fundamental value is what it should be purchased at. If its market price is below Rs. 30 buy it, but not if it is any higher. One bubble burst in 2008. The next bubble may not be far away. You must always beware of this possibility.

Industry Analysis The importance of industry analysis is now dawning on the Indian investor as never before. Previously, investors purchased shares of companies without concerning themselves about the industry it operated in. And they could get away with it three decades ago. This was because India was a sellers’ market at that time and products produced were certain to be sold, often at a premium. Those happy days are over. Now, there is intense competition. Consumers have now become quality, cost and fashion conscious. Foreign goods are easily available and Indian goods have to compete with these. There are great technological advances and “state of the art” equipment becomes obsolete in a few years. If not months. In the late 1970s and early 1980s, movie cameras and projectors were prized possessions. With the advent of the video camera in the mid 80s they became obsolete. In 1988, laptop computers were the “in” thing. Everyone raved about the invention and how technology could compress a huge computer into such a small box. These early models did not have a hard disk but two fixed disk drives. A few months later hard disks were incorporated, initially having a capacity of 20 megabytes. The memory was then increased to 40 megabytes. In eighteen months, the laptop became obsolete with the creation of the notebook. These notebooks, some having a capacity of as much as 120 megabytes, are still not the last word in compressed computing. The palm tops have now arrived. Mobile phones today have computing capabilities. One really and honestly does not know what will be next. I have used these examples to illustrate how technological advances make a highly regarded product obsolete. In the same way, technological advances in one industry can affect another industry. The jute industry went into decline when alternate and cheaper packing materials began to be used. The popularity of cotton clothes in the West affected the manmade (synthetic) textile industry. An investor must therefore examine the industry in which a company operates because this can have a tremendous effect on its results, and even its existence. A company’s management may be superior, its balance sheet strong and its reputation enviable. However, the company may not have diversified and the industry within which it operates may be in a depression. This can result in a tremendous decline in revenues and even threaten the viability of the company.

Cycle The first step in industry analysis is to determine the cycle it is in, or the stage of maturity of the industry. All industries evolve through the following stages: 1. 2. 3. 4.

Entrepreneurial, sunrise or nascent stage, Expansion or growth stage, Stabilization, stagnation or maturity stage, and Decline or sunset stage.

The life cycle of an industry can be illustrated in an inverted “S” curve as illustrated above. The Entrepreneurial or Nascent Stag e

At the first stage, the industry is new and it can take some time for it to properly establish itself. In these early days, it may actually make losses. At this time there may also not be many companies in the industry. It must be noted that the first 5 to 10 years are the most critical period. At this time, companies have the greatest chance of failing. It takes time to establish companies and new products. There may be losses and the need for large injections of capital. If a company or an industry is not nurtured or husbanded at this stage, it can

collapse. A good journalist I know began a business magazine. His intention was to start a magazine edited by journalists without interference from industrial magnates or politicians. It was an exceptionally readable magazine. However, it did not have the finance needed in those critical initial years to keep it afloat and had to fold up. Had it, at that time, had the finance it needed it may have survived and thrived. In short, at this stage investors take a high risk in the hope of great reward should the product succeed. The Expansion or Growth Stage

Once the industry has established itself it enters a growth stage. As the industry grows, many new companies enter the industry. At this stage, investors can get high reward at low risk since demand outstrips supply. In 2000, a good example was the Indian software industry. In 2003, the BPO industry is arguably in the growth stage. The mobile phone industry is also in the growth stage — with newer models and newer entrants. The growth stage also witnesses product improvements by companies that have survived the first stage. In fact, such companies are often able to even lower their prices. Investors are more keen to invest at this time as companies would have demonstrated their ability to survive. The Stabilization or Maturity Stag e

After the halycon days of growth, an industry matures and stabilizes. Rewards are low and so too is the risk. Growth is moderate. Though sales may increase, they do so at a slower rate than before. Products are more standardized and less innovative and there are several competitors. The refrigerator industry in India is a mature industry. Growth is slow. It is for the time seeing safe. Investors can invest in these industries for comfort and average returns. They must be aware though that should there be a downturn in the economy and a fall in consumer demand, growth and returns can be negative. The Decline or Sunset Stag e

Finally, the industry declines. This occurs when its products are no longer popular. This may be on account of several factors such as a change in social habits (the film and video industry, for example, has suffered on account of cable and satellite television), changes in laws, and increase in prices. The risk at this time is high but the returns are low, even negative. The various stages can be likened to the four stages in the life cycle of a human being — childhood, adulthood, middle age and old age. Investors should begin to purchase shares when an industry is at the end of the entrepreneurial or nascent stage and during its growth stage, and should begin

to disinvest when at its mature stage.

The Industry vis-a-vis the Economy Investors must ascertain how an industry reacts to changes in the economy. Some industries do not perform well during a recession, others exhibit less buoyancy during a boom. On the other hand, certain industries are unaffected in a depression or a boom. What are the major classifications? 1. Industries that are generally unaffected during economic changes are the evergreen industries. These are industries that produce goods individuals need, like the food or agro-based industries (dairy products, etc.) 2. Then there are the volatile cyclical industries which do extremely well when the economy is doing well and do badly when depression sets in. The prime examples are durable goods, consumer goods such as textiles and shipping. During hard times individuals postpone the purchase of consumer goods until better days. 3. Interest sensitive industries are those that are affected by interest rates. When interest rates are high, industries such as real estate and banking fare poorly. 4. Growth industries are those whose growth is higher than other industries and growth occurs even though the economy may be suffering a setback. What should investors do? Investors should determine how an industry is affected by changes in the economy and movements in interest rates. If the economy is moving towards a recession, investors should disinvest their holdings in cyclical industries and switch to growth or evergreen industries. If interest rates are likely to fall, investors should consider investment in real estate or construction companies. If, on the other hand, the economy is on the upturn, investment in consumer and durable goods industries are likely to be profitable.

Competition Another factor that one must consider is the level of competition among various companies in an industry. Competition within an industry initially leads to efficiency, product improvements and innovation. As competition increases even more, cut throat price wars set in resulting in lower margins, smaller profits and, finally, some companies begin to make losses. The more inefficient companies even close down. To properly understand this phenomenon, it is to be appreciated that if the return is high, newcomers will invest in the industry and there will be an inflow of funds. Existing companies may also increase their capacity. However, if the returns are low, or lower than that which can be obtained elsewhere, the reverse will occur. Funds will not be invested and there will be an outflow. In short high returns attract competition and vice versa. However, competition in the form of new companies do not bacterially multiply just because the returns are high. There are competitive forces and it is these competitive forces determine the extent of the inflow of funds, the return on investment and the ability of companies to sustain these returns. These competitive forces are: barriers to entry, the threat of substitution, bargaining power of the buyers, bargaining power of the suppliers, and the rivalry among competitors. Barriers to Entry

New entrants increase the capacity in an industry and the inflow of funds. The question that arises is how easy is it to enter an industry? There are some barriers to entry: 1. Economies of Scale: In some industries it may not be economical to set up small capacities. This is especially true if comparatively large units are already in existence producing a vast quantity. The products produced by such established giants will be markedly cheaper. 2. Product Differentiation: A company whose products have product differentiation has greater staying power. The product differentiation may be because of its name or because of the quality of its products — Mercedes Benz cars; National VCRs or Reebok shoes. People are prepared to pay more for the product and consequently the products are at a premium. It is safe usually to invest in such companies as there will

always be a demand. Capital Requirement: Easy entry industries require little capital and technological expertise. As a consequence, there are a multitude of competitors, intense competition, low margins and high costs. On the other hand, capital intensive industries with a large capital base and high fixed cost structure have few competitors as entry is difficult. The automobile industry is a prime example of such an industry. Its high fixed costs have to be serviced and a fall in sales can result in a more than proportionate fall in profits. Large investments and a big capital base will be barriers to entry. Switching Costs: Another barrier to entry could be the cost of switching From one supplier ’s product to another. This may include employee retraining costs, cost of equipment and the likes. If the switching costs are high, new entrants have to offer a tremendous improvement for the buyer to switch. A prime example is computers. A company may be using a honeywell computer. If it wishes to change to an IBM computer, all the terminals, the unit and even the software would have to be changed. Access to Distribution Channels: Difficulty in securing access to distribution channels can be a barrier to entry, especially if existing firms already have strong and established channels. Cost Disadvantages Independent of Scale: This barrier occurs when established firms have advantages new entrants cannot replicate. These include: Proprietary product technology; Favourable access to raw materials; Government subsidies; Long learning curves. A prime example is Coca Cola. The company has proprietary product technology. Similar cold drinks are available but it is not easy for a competitor to compete with it.

7. Government Policy: Government policy can limit fresh entrants to an industry, usually by not issuing licenses. Till about the mid-1980s, the Indian motor car industry was the monopoly of two companies. Even though others sought licenses these were not given.

8. Expected Retaliation: The expected retaliation by existing competitors can also be a barrier to potential entrants, especially if existing competitors aggressively try to keep the new entrants out. 9. Cost of Capacity Additions: If the cost of capacity additions are high, there will be fewer competitors entering the industry. 10. International Cartels: There may be international cartels that make it unprofitable for new entrants. The Threat of Substitution

New inventions are always taking place and new and better products replace existing ones. An industry that can be replaced by substitutes or is threatened by substitutes is normally an industry one must be careful of investing in. An industry where this occurs constantly is the packaging industry — bottles replaced by cans; cans replaced by plastic bottles, and the like. To ward off the threat of substitution, companies often have to spend large sums of money in advertising and promotion. The industries that have to worry most are those where the substitutes are either cheaper or better, or are produced by industries earning high profits. It should be noted that substitutes limit the potential returns of a company. Barg aining Power of the Buyers

In an industry where buyers have control, i.e. in a buyer ’s market, buyers are constantly forcing prices down, demanding better services or higher quality and this often erodes profitability. The factors one should check are whether: A particular buyer buys most of the products (large purchase volumes). If such buyers withdraw their patronage, they can destroy an industry. They can also force prices down. Buyers can play one company against another to bring prices down. One should also be aware that: If sellers face large switching costs, the buyer ’s power is enhanced. This is especially true if the switching costs for buyers are low. If buyers have achieved partial backward integration, sellers face a threat as they may become fully integrated. If buyers are well informed about trends and details they are in a better

position vis-a-vis sellers as they can ensure they do not pay more than they need to. If a product represents a significant portion of the buyers’ cost, buyers would strongly attempt to reduce prices. If a product is standard and undifferentiated, the buyer ’s bargaining power is enhanced. If the buyer ’s profits are low, the buyer will try to reduce prices as much as possible. In short, an industry that is dictated by buyers is usually weak and its profitability is under constant threat. Barg aining Power of the Suppliers

An industry unduly controlled by its suppliers is also under threat. This occurs when: The suppliers have a monopoly, or if there are few suppliers. Suppliers control an essential item. Demand for the product exceeds supply. The supplier supplies to various companies. The switching costs are high. The supplier ’s product does not have a substitute. The supplier ’s product is an important input for the buyer ’s business. The buyer is not important to the supplier. The supplier ’s product is unique. Rivalry Among Competitors

Rivalry among competitors can cause an industry great harm. This occurs mainly by price cuts, heavy advertising, additional high cost services or offers, and the like. This rivalry occurs mainly when: There are many competitors and supply exceeds demand. Companies resort to price cuts and advertise heavily in order to attract customers for their goods. The industry growth is slow and companies are competing with each other for a greater market share.

The economy is in a recession and companies cut the price of their products and offer better service to stimulate demand. There is a lack of differentiation between the product of one company and that of another. In such cases, the buyer makes his choice on the basis of price or service. In some industries economies of scale will necessitate large additions to existing capacities in a company. The increase in production could result in over capacity and price cutting. Competitors may have very different strategies in selling their goods and in competing they may be continuously trying to stay ahead of the other by price cuts or improved service. Rivalry increases if the stakes (profits) are high. Firms will compete with one other intensely if the costs of exit are great, i.e. the payment of gratuity, unfunded provident fund, pension liabilities, and such like. In such a situation, companies would prefer remaining in business even if margins are low and little or no profits are being made. Companies also tend to remain in business at low margins if there are strategic interrelationships between the company and others in the group; due to government restrictions (the government may not allow a company to close down); or in case the management does not wish to close down the company out of pride or employee commitment. If exit barriers are high, excess capacity can not be shut down and companies lose their competitive edges; profitability is eroded. If exit barriers are high the return is low but risky. If exit barriers are low the return is low but stable. On the other hand, if entry barriers are low the returns are high but stable. High entry barriers have high, risky returns. Entry Barriers Exit Barriers

Chart 5.1 High Return high but risky Return low but risky

Low Return high but stable Return low and stable

Selecting an Industry When choosing an industry, it would be prudent for the investor to bear in mind or determine the following details: 1. Invest in an industry at the growth stage. 2. The faster the growth of a company or industry, the better. Indian software industry, for example, was growing at a rate of more than 50 per cent per annum at the dawn of the new millennium. 3. It is safer to invest in industries that are not subject to governmental controls and are globally competitive. 4. Cyclical industries should be avoided if possible unless one is investing in them at the time the industry is prospering. 5. Export oriented industries are presently in a favourable position due to various incentives and government encouragement. On the other hand, import substitution companies are presently not doing very well due to relaxations and lower duties on imports. 6. It is important to check whether an industry is right for investment at a particular time. There are sunrise and sunset industries. There are capital intensive and labour intensive industries. Each industry goes through a life cycle. Investments should be at the growth stage of an industry and disinvestment at the maturity or stagnation stage before decline sets in.

Part Three Company Analysis

At the final stage of fundamental analyses, the investor analysis the company. This analysis has two thrusts: How has the company performed vis-a-vis other similar companies; and How has the company performed in comparison to earlier years? It is imperative that one completes the politico economic analysis and the industry analysis before a company is analyzed because the company’s performance at a period of time is to an extent a reflection of the economy, the political situation and the industry. What does one look at when analysing a company? There is, in my view, no point or issue too small to be ignored. Everything matters. As I had mentioned earlier, the billionaire Jean Paul Getty, one of the most successful stock market operators of all time, said, “Do not buy a stock until you know all about it.” The different issues regarding a company that should be examined are: The Management The Company The Annual Report Ratios Cash flow.

The Management The single most important factor one should consider when investing in a company, and one often never considered, is its management. It is upon the quality, competence and vision of the management that the future of a company rests. A good, competent management can make a company grow while a weak, inefficient management can destroy a thriving company. Corporate history is riddled with examples. Chrysler was an ailing giant, in the early eighties. Iacocca turned the company round with tough competent management. In the first quarter of 1993, the big blue — IBM — dismissed its Chief Executive Officer Akers who was blamed for the company’s dismal performance. Lou Gerstner who was at one time President of American Express and later took charge of R. J. R. Nabisco was invited to become the Chief Executive Officer of IBM. Mr. Gerstner had earlier been successful in reducing quite drastically and very impressively the liabilities that had arisen on account of the leveraged buy out of R. J. R. Nabisco. It was this success that was instrumental in his getting the top job at IBM. Similarly, the main reason attributed for the collapse in the seventies of Penn Central, the largest railway in the United States, was that it was headed by Stuart Saunders who was a lawyer and possessed little understanding of what was involved in running a large railway network. Indian corporate history also has many such examples. Metal Box was a name known and respected, the bluest of blue chips. After a series of occurrences including a diversification that went wrong, the company was forced to close all its factories. Killick Nixon was one of the most respected names in Western India. No longer. On the other hand, there are numerous success stories, of prosperity that resulted due to the foresight and vision of management. Haksar diversified ITC into hotels (the Welcomgroup chain); his successor diversified into agro based industries. These have been successes. The success of Videocon could probably be attributed to Venugopal Dhoot, Bajaj Auto’s growth and profitability is due to Rahul Bajaj, and the Reliance Empire due entirely to one man, Dhirubhai Ambani. There are several others such as Azim Premji and Wipro, Narayanamurthy and Infosys and HDFC and Deepak Parekh. In India, management can be broadly divided into two types: Family management; Professional management.

Family Management Family managed companies are those that have at the helm a member of the controlling family. The Chairman or the Chief Executive Officer is usually a member of the “ruling” family and the Board of Directors are peopled either by members of the family or their friends and “rubber stamps”. This is not necessarily bad. It is just that all policy is determined by the controlling family and some of the policies may not necessarily always be in the shareholders’ best interest. I remember a few years ago Kirloskar Pneumatics was quoting at Rs. 36 per share. At that time Kirloskar Tractors was not doing well. The controlling family merged the two companies and the price of Kirloskar Pneumatic fell to around Rs. 10. It was probably good for the family and for the shareholders of Kirloskar Tractors but the merger was disastrous for the shareholders of Kirloskar Pneumatics. In short, decisions are often made with family interests in view and employees are often treated as paid servants of the family even though they may be senior managers. For instance, in one company I know the Human Resources Manager is also involved in hiring maids and houseboys for his Chairman’s house and he buys the vegetables, too. The New Delhi manager, whenever his “Seth” visits that city is expected to be at the company house every morning at 7 a.m. when the Chairman wakes up, and can only leave his master ’s presence after he retires for the night. I was witness to an incident at Bombay airport many years ago. The head of a large business house was going on a trip. The chief executives of his many companies had come to see him off. These gentlemen were well known individuals, captains of industry in their own right and respected for their achievements and accomplishments. These leaders bent double and touched their leader ’s feet when he left, and three of them were actually older than their master. Possibly, this may have been done as a sign of respect like a student touching his teacher ’s feet, but I do wonder what may have occurred if these individuals had not humiliated themselves with this gesture of obeisance. What I am trying to point out is that in many family run companies, employees are expected to be subservient to the family and loyalty to the family is considered even more important than talent. And often this loyalty is rewarded. If a retainer is ill, he is looked after well and all his medical expenses are borne by the family. When he retires he is given a good pension. I remember an occasion when a senior employee died. His widow was given the company flat, the children were educated and she was even given a job. Few professionally managed or multinationals would do this.

Mr. T. Thomas, a former Chairman of Hindustan Lever Ltd., describes the family business structure most eloquently in his memoir, To Challenge and to Change. He speaks of an Indian family business having a series of concentric circles emanating from a core — the core being made up of the founder and his brothers or sons. The next circle is the extended family of cousins and relatives followed by people from the same religious or caste group. The fourth circle comprises of people from the same language group and the outermost circle has people from the same region. Mr. Thomas says that to go beyond this was “like going out of orbit — unthinkably risky”. There has been some change in the way family controlled businesses have been managed. In the beginning, these were often orthodox, autocratic, traditional, rigid and averse to change. This is no longer true. The sons and the grandsons of the founding fathers have been educated at the best business schools in India or abroad and they have been exposed to modern methods. Consequently, in many family managed companies, although the man at the helm is a scion of the family, his subordinates are graduates of business schools, i.e. professional managers. To an extent this combines the best of two worlds and many such businesses are very successful. The frustration for the professional manager in such companies is that he knows that he will never, ever run the company; that privilege will always be with a member of the family.

Professional Management Professionally managed companies are those that are managed by employees. In such companies, the chief executive officer often does not even have a financial stake in the company. He is at the helm of affairs because of his ability and experience. The professional manager is a career employee and he remains at the seat of power so long as he meets his targets. Consequently, he is always resultoriented and his aim is often short term — the meeting of the annual budget. He is not necessarily influenced by loyalty to the company. As a professional he is usually aware of the latest trends in management philosophy and tries to introduce these. He tries to run his company like a lean, effective machine striving for increased efficiency and productivity. As a consequence, professionally managed companies are usually well organized, growth oriented and good performers. Investors are the recipients of regular dividends and bonus issues. The companies that come readily to mind are ITC, Infosys, HDFC and Hindustan Lever. However, there is often a lack of long term commitment and sometimes a lack of loyalty. This is because the professional manager has to step down in time, to retire, and he cannot therefore enjoy the fruit of his labour for ever. Nor will his sons succeed him although some may try to see that this happens. One must also not forget that the professional manager is a mercenary. He sells his services to the highest bidder, and such individuals are consequently not usually known for their loyalty. Companies now try to promote or create commitment by offering employees stock options. These devolve on employees after a specified period of service and are given to them on performance. The employee thus becomes a part owner and becomes thus involved in the profitability of the enterprise. Additionally as these devolve on the employee only after a time, he tends to stay till it does. As these options are given, often annually, the employee remains with the company for a significant period of time. It is a win-win situation for both. The company gets the services of a loyal competent employee. The employee builds his net worth. In many professionally managed companies there is also a lot of infighting and corporate politics. This is because managers are constantly trying to climb up the corporate ladder and the end is often what matters, not the means. Often too, as a consequence, the best person does not get the top job; rather, it is the person who plays the game best. This does not always happen in family

managed companies as one is aware that the mantle of leadership will always be worn by the son or daughter of the house. What to Look For

It would be unfair to state that one should invest only in professionally managed companies or family managed companies. There are well managed, profitable companies in both categories. There are also badly managed companies in both categories. What then are the factors one should look for? 1. In my opinion, the most important aspect is the integrity of the management. This must be beyond question. It is often stated that a determined employee can perpetrate a fraud, despite good systems and controls. Similarly, if it so desires, the management can juggle figures and cause great harm and financial loss to a company (for their own personal gain). My recommendation would therefore be to leave a company well alone if you are not too certain of the integrity of its management. I had the privilege once to listen to Mr. C. S. Patel who was at one time the Chief Executive of Unit Trust of India. He recounted an advice he was given by his mentor, Mr. A. D. Shroff, the erstwhile Chairman of the New India Assurance: “If you have the slightest doubt of management, do not touch the company with a pair of tongs.” Seldom have I heard truer words. When, in a conversation about a company, its management is described colloquially as “chor (thief) management”, it is a hint to keep well away from that company. In this context, one should check who the major shareholders of the company are. There are some managements who have a record of manipulating share prices. I was recounted a tale wherein a non Indian journalist asked the scion of a family managed company how he could claim that the share price of his company would not fall below Rs. 230. The worthy replied, “We will not allow it to.” Shares of such companies are speculative shares and artificially kept at a high price. They must be avoided. 2. Another point to consider is proven competence, i.e. the past record of the management. How has the management managed the affairs of the company during the last few years? Has the company grown? Has it become more profitable? Has it grown more impressively than others in the same industry? It is always wise to be a little wary of new management and new companies as they have a very high level of mortality. Wait until the

company shows signs of success and the management proves its competence. 3. How highly is the management rated by its peers in the same industry? This is a very telling factor. Competitors are aware of nearly all the strengths and weaknesses of a management and if they hold the management in high esteem it is truly worthy of respect. It should be remembered that the regard the industry has of the management of a company is usually impartial, fair and correct. 4. In good times everyone does well. The steel of a management is tested at times of adversity? And during a time of recession or depression, it is important to consider how well the management did? Did it streamline its operations? Did it close down its factories? Did it (if it could) get rid of employees? Was it able to sell its products? Did the company perform better than its competitors? How did sales fare? A management that can steer its company in difficult days will normally always do well. 5. The depth of knowledge of the management, its knowledge of its products, its markets and the industry is of paramount importance because upon this can depend the success of a company. Often the management of a company that has enjoyed a pre-eminent position sits back thinking that it will always be the dominant company. In doing so, it loses its touch with its customers, its markets and its competitors. The reality sinks in only when it is too late. The management must be in touch with the industry and customers at all times and be aware of the latest techniques and innovations. Only then can it progress and keep ahead. A quick way of checking this is to determine what the market share of the company’s products is, and whether the share is growing or at least being maintained. 6. The management must be open, innovative and must also have a strategy. It must be prepared to change when required. It must essentially know where it is going and have a plan of how to get there. It must be receptive to ideas and be dynamic. A company that has many layers of management and is top heavy tends to be very bureaucratic and ponderous. There are “many chiefs and few braves”. They do not want change and often stand in the way of change. Their strategy is usually a personal one, on how to hold onto their jobs. 7. I would not recommend investing in a company that is yet to professionalize because in such companies decisions are made on the whims of the chief executive and not with the good of the company in mind. In such companies the most competent are not given the positions of

power. There may be nepotism with the nephews, nieces, cousins and relatives of the chief executive holding positions not due to proven competence but because of blood ties. 8. It would be wise, too, to avoid investing in family controlled companies where there is infighting because the companies suffer and the one who arguably stands to lose the most is the shareholder or the investor. In recent years, many such family controlled companies have split, the Birlas, the Goenkas, the Mafatlals, to name but a few. The period before the split and the period soon after are the most unsettled times. That is the time to keep away from such companies. When the new management settles down, one can determine whether one should invest or not. In India, many of the larger companies are family controlled though they are managed on a day-to-day basis by professional managers. There are also several professionally managed companies. It is not possible, nor would it be fair, to generalize which is better. An investor must, before he risks his money, decide whether he is comfortable with the management of a company. Ultimately, this is what will determine the safety and the fate of the money that you invest.

The Company An aspect not necessarily examined during an analysis of fundamentals is the company. This is because the company is one’s perception of the state of a company — it cannot necessarily be supported by hard facts and figures. A company may have made losses consecutively for two years or more and one may not wish to touch its shares — yet it may be a good company and worth purchasing into. There are several factors one should look at. One of the key factors to ascertain is how a company is perceived by its competitors. Is it held in high regard? The Oscar is Hollywood’s greatest award, the one most prized by the stars. Why? It is because it represents recognition of an actor / actress by his / her peers. A company held in scorn by a competitor is not worth looking at. On the other hand, one held in awe must be considered not once but several times. Its products may be far superior. It may be better organized. Its management may be known for its maturity, vision, competence and aggressiveness. The investor must ascertain the reason and then determine whether the reason will continue into the foreseeable future. Another aspect that should be ascertained is whether the company is the market leader in its products or in its segment When you invest in market leaders, the risk is less. The shares of market leaders do not fall as quickly as those of other companies. There is a magic to their name that would make individuals prefer to buy their products as opposed to others. Let us take a real life example. In the eighties, there was a virtual explosion of consumer goods. There were many television manufacturers. They made similar televisions as almost all parts were imported. However, within a decade only those that were the market leaders survived. The others had died off. If one has to purchase an article and has a choice one would normally buy the better one. This is normal human behaviour and this happens in the market place too. Consequently, the prices of market leaders fall slower than those of others in the same industry. The policy a company follows is also of imperative importance. What is its plans for growth? What is its vision? Every company has a life. If it is allowed to live a normal life it will grow up to a point and then begin to level out and eventually die. It is at the point of levelling out that it must be given new life. This can give it renewed vigour and a new lease of life. A classic example that comes to mind is ITC Ltd. This tobacco giant branched into hotels under Haksar and then into agribusiness under Sapru. Reliance Industries was initially in Textiles. It then saw opportunity and moved into petroleum, into

petro chemicals and refining products. It has in 2003 got into mobile phones. Blue Star is a airconditioning company. It had a software division which was spun off as a separate company. Since then both these companies have grown. Labour relations are extremely important. A company that has motivated, industrious work force has high productivity and practically no disruption of work. On the other hand, a company that has bad industrial relations will lose several hundred man days as a consequence of strikes and go slows. In 1992 Bata, the giant shoe company, was closed due to strikes for nearly four months and as a consequence its results in the year to 31 March 1993 were extremely bad. It is widely believed that the textile industry died in Mumbai because of the militancy of the unions under the late Datta Samant. It was on account of the militancy of the labour force that many companies grew reluctant to invest in states such as Kerala and West Bengal. It is critical, therefore, to ascertain where the company’s plants and factories are and their record of industrial relations. One must also consider where the company is located and where its factories are. If the infrastructure is bad, if there is inadequate electricity or water the company could have tremendous problems. There are many companies in Madhya Pradesh in dire straits because of electricity cuts. Many cannot afford captive power. Transportation is another issue. The government has recognized this and there are plans afoot to have superhighways around the country within the next ten years. These are the main factors one should keep at the back of one’s mind while viewing a company.

The Annual Report The primary and most important source of information about a company is its Annual Report. By law, this is prepared every year and distributed to the shareholders. Annual Reports are usually very well presented. A tremendous amount of data is given about the performance of a company over a period of time. Multicoloured bar and pie charts are presented to illustrate and explain the growth of the company and the manner in which the revenues earned have been utilized. There are pictures of the factories; of newly acquired machines; of the Chairman cutting a ribbon and of the Board of Directors looking responsible. The average shareholder looks no further. If an Annual Report is impressive, if the company has made a profit and if a reasonable dividend has been paid, he is typically content in the belief that the company is in good hands. This must not be the criteria by which to judge a company. The intelligent investor must read the annual report in depth; he must read between and beyond the lines; he must peep behind the figures and find the truth and only then should he decide whether the company is doing well or not. The Annual Report is broken down into the following specific parts: 1. 2. 3. 4.

The Directors’ Report, The Auditor ’s Report, The Financial Statements, and The Schedules and Notes to the Accounts.

Each of these parts has a purpose and a tale to tell. The tale should be heard. The Directors’ Report The Directors’ Report is a report submitted by the directors of a company to its shareholders, advising them of the performance of the company under their stewardship. It is, in effect, the report they submit to justify their continued existence and it is because of this that these reports should be read with a pinch of salt. After all, if a group of individuals have to present an evaluation of their own performance they are bound to highlight their achievements and gloss over their failures. It is natural. It is human nature. Consequently, all these

reports are very well written. Every sentence, nay every word, is subjected to the most piercing scrutiny. Every happening of importance is catalogued and highlighted to convince a casual reader that the company is in good hands. And there is a tendency to justify unhappy happenings. Nevertheless, the Directors’ Report provides an investor valuable information: 1. It enunciates the opinion of the directors on the state of the economy and the political situation vis-a-vis the company. 2. Explains the performance and the financial results of the company in the period under review. This is an extremely important part. The results and operations of the various separate divisions are usually detailed and investors can determine the reasons for their good or bad performance. 3. The Directors’ Report details the company’s plans for modernization, expansion and diversification. Without these, a company will remain static and eventually decline. 4. Discusses the profit earned in the period under review and the dividend recommended by the directors. This paragraph should normally be read with sane sckepticism as the directors will always argue that the performance was satisfactory. If profits have improved it would invariably because of superior marketing and hard work in the face of severe competition. If low, adverse economic conditions are usually at fault!. 5. Elaborates on the directors views of the company’s prospects in the future. 6. Discusses plans for new acquisitions and investments. An investor must intelligently evaluate the issues raised in a Directors’ Report. Diversification is good but does it make sense? Industry conditions and the management’s knowledge of the business must be considered. A diversification in recent times that was a disaster was Burroughs Wellcome’s diversification into sport goods, Nike Sportswear in particular. So was Metal Box’s move into ball bearings and Spartek’s acquisition of Neycer Ceramics. The point I am trying to make is that although companies must diversify in order to spread the risks of industrial slumps, every diversification may not suit a company. Similarly, all other issues raised in the Directors’ Report should be analyzed. Did the company perform as well as others in the same industry? Is the finance being raised the most logical and beneficial for the company? It is imperative that the investor read between the lines of Directors’ Report and find the answers to these questions.

In short, a Directors’ Report is valuable and if read intelligently can give the investor a good grasp of the workings of a company, the problems it faces, the direction it intends takings, and its future prospects. The Auditor’s Report The auditor represents the shareholders and it is his duty to report to the shareholders and the general public on the stewardship of the company by its directors. Auditors are required to report whether the financial statements presented do, in fact, present a true and fair view of the state of the company. Investors must remember that the auditors are their representative and that they are required by law to point out if the financial statements are not true and fair. They are also required to report any change, such as a change in accounting principles or the non provision of charges that result in an increase or decrease in profits. It is really the only impartial report that a shareholder or investor receives and this alone should spur one to scrutinise the auditor ’s report minutely. Unfortunately, more often than not it is not read. There can be interesting contradictions. It was stated in the Auditor ’s Report of ABC Ltd for the year 2009-2020 that, “As at the year end 31st March 2020, the accumulated losses exceed the net worth of the Company and the Company has suffered cash losses in the financial year ended 31st March 2020 as well as in the immediately preceding financial year. In our opinion, therefore, the Company is a sick industrial company within the meaning of clause (O) of Section 3(1) of the Sick Industrial Companies (Special Provisions) Act 1985”. The Directors’ report however stated, “The financial year under review has not been a favourable year for the Company as the Computer Industry in general continued to be in the grip of recession. High input costs as well as resource constraints hampered operations. The performance of your Company must be assessed in the light of these factors. During the year manufacturing operations were curtailed to achieve cost effectiveness . . . . Your directors are confident that the efforts for increased business volumes and cost control will yield better results in the current year”. The auditors were of the opinion that the company was sick whereas the directors spoke optimistically of their hope that the future would be better! I suppose they could not, being directors, state otherwise. When reading an Auditor ’s Report, the effect of their qualification may not be apparent. The Auditor ’s Report of Royston Electronics Limited for 20092020 stated: “In our opinion and to the best of our information and explanation

given to us, the said accounts subject to Note No. 3 regarding doubtful debts, No. 4 regarding balance confirmations, No. 5 on custom liability and interests thereon, No 11 on product development expenses, No. 14 on gratuity, No. 8, 16 (C) and 16(F) regarding stocks, give the information in the manner as required by the Companies Act 1956, and give a true and fair view. Let us now look at the specific notes in this case: 1. Note 3 stated that no provision had been made for doubtful debts. 2. It was noted in Note 4 that balance confirmation of sundry debtors, sundry creditors and loans and advances had not been obtained. 3. It was stated in Note 5 that customs liability and interest thereon worth Rs. 3,14,30,073 against the imported raw materials lying in the ICF / Bonded godown as on 31.3.2020 had not been provided. 4. Note 11 drew attention to the fact that product development expenses worth Rs. 17,44,049 were being written off over ten years from 20092020. Rs. 2,16,51,023 had been capitalised under this head relating to the development of CT142, Digital TV, Cooler, CFBT which shall be written off in 10 years commencing 2020-11. 5. The company’s share towards past gratuity liabilities as of 31 March 2020 had neither been ascertained nor provided for except to the extent of premiums paid against an LIC group gratuity policy taken by the trust (Note 14). 6. Note 16C stated that the raw material consumed had been estimated by the management and this had not been checked by the auditors. The company made a profit of just over Rs. 1 crore. If the product development expenses, customer duty and interest and provision for bad debts had been made as is required under generally accepted accounting principles, the profit would have turned into a loss. The point to remember is that at times accounting principles are changed, or creative and innovative accounting practices resorted to by some companies in order to show a better result. The effect of these changes is at times not detailed in the notes to the accounts. The Auditor ’s Report will always draw the attention of the reader to these changes and the effect that these have on the financial statements. It is for this reason that a careful reading of the Auditor ’s Report is not only necessary but mandatory for an investor.

Financial Statements The published financial statements of a company in an Annual Report consist of its Balance Sheet as at the end of the accounting period detailing the financial condition of the company at that date, and the Profit and Loss Account or Income Statement summarizing the activities of the company for the accounting period. Fundamental Ltd. Balance Sheet as at 31 March 2020 Sources of Funds Shareholders’ funds: (a) Capital (b) Reserves

Loan funds: (a) Secured Loans (b) Unsecured Loans Total Application of Funds Fixed Assets Investments Current Assets: Trade debtors Prepaid Expenses Cash and Bank balances Other Current Assets Less: Current Liabilities and provisions Trade Creditors Accrued Expenses Sundry Creditors Net current assets Total

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