What is CRR, repo and reverse repo rate?

What is CRR? Cash reserve Ratio (CRR) is the amount of funds that the banks have to keep with the RBI. If the central bank decides to increase the CRR, the available amount with the banks comes down. The RBI uses the CRR to drain out excessive money from the system. Commercial banks are required to maintain with the RBI an average cash balance, the amount of which shall not be less than 3% of the total of the Net Demand and Time Liabilities (NDTL), on a fortnightly basis and the RBI is empowered to increase the rate of CRR to such higher rate not exceeding 20% of the NDTL. What is Reverse Repo rate? Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money are in safe hands with a good interest. An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system. What is a Repo Rate? The rate at which the RBI lends money to commercial banks is called repo rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI. A reduction in the repo rate helps banks get money at a cheaper rate and vice versa. The repo rate in India is similar to the discount rate in the US.

Investing in Gold ?

Investing Basics - What is inflation?

Investor wealth eroded

Amid the financial crisis in the US, Indian investors have witnessed an erosion of about Rs 2.3 lakh crore in their wealth in September, says a report.

Domestic equity market continued to be battered following negative global cues with the benchmark Nifty registering a fall of about 10 % in the last month.

"It is estimated that Rs 2.3 lakh crore of shareholders' wealth eroded in the background of the situation in the US financial markets," Crisil Research said in a report.

On the contrary, the fall in the US markets was lower with the S&P 500 and Dow Jones both declining by around nine % and six %, respectively, while emerging markets lost around 18 % during the month.

Pessimism in the financial markets following the filing for bankruptcy by Lehman Brothers, Merrill Lynch's sell-off, the bail out of AIG and perceived uncertainty around the US bail-out package added to investor fears.

Investor sentiment was also affected on news of the possibility of Fortis filing for bankruptcy, indicating problems in the European financial markets as well, the report added.

"The BSE Realty Index and the BSE Metal Index were the most severely affected during the month, dropping by 32 per cent and 25 %, respectively. Concerns over slowing demand in the real estate market due to a liquidity crunch and increased cost of funding weighed in on investor sentiment in the realty sector," Crisil Research Head-Equities Chetan Majithia said.

Dos and don'ts in stock picking

If you are an investor on the look out for undiscovered stocks with great growth prospects, be assured you are not the only one! With the stock market no longer predictable, chancing upon value buys in the current market is no more anybody's game. If the bull market that made us all feel like geniuses, remember that the same market, when in a downward or sideways mood, can make fools out of geniuses too. The point is though stock picking in this market is not impossible, it is not going to be easy either. You would have to exercise more caution and restraint.

Though there are no foolproof ways of stock picking, there are some dos and don'ts to help invest wisely. Here are some of them.

Stick to fundamentals

Remember to put money only in those stocks that you think are well-placed fundamentally. A company in a known business with reasonable financials is likely to provide better returns over the long term than one without a convincing business model or history.

Keep in mind that returns, in most cases, are commensurate with the risk you are willing to take. Hence, you would be better off keeping a moderate return expectation from your investments if you plan to stick to the safe bets (read fundamentally good stocks) in the market.

Do your own homework

Nobody can comprehend your investment needs relative to your risk tolerance better than yourself. Hence, it is advisable to do your own homework on any stock you plan to invest in, especially when the market appears volatile. Basing your investment decision on your broker or even a successful trader friend whom you consider the ultimate authority on the stock market, can prove to be costly at times.

Buy in instalments

Once you have identified a good stock to buy, it may also make sense to consider accumulating stocks in small lots, over a period.

Notwithstanding the short-term price fluctuations that can act against you, this strategy is likely to help mitigate the risk of buying stocks at a high price, thanks to the benefits of averaging your investment.

Furthermore, it would also ensure that at any point of time, you are left with cash to buy stocks when the market appears weak. Similarly, you can also consider pyramiding your profits on stocks when the stock price appreciates, that us, selling small lots at different prices.

Confront your fear of regret

If you regret not having invested in a particular stock (a multi-bagger now) that your friend or broker recommended in the past and feel compelled to do so in the latest recommendation from them, think twice. Investment decisions cannot be emotional ones. Moreover, markets always throw up opportunities to make money and, hence, an opportunity lost is certainly not the end.

Fear of regret can also creep in when you invest in a stock recommended by your friend, after which it tanks 50 per cent. This could prompt you to stay away from even good stocks that are recommended later on. Though stock markets are sentiment-driven, remember that it always pays to make informed decisions rather than emotional ones.

All said and done, these are only guidelines to assist you in picking the right stocks. At the end of the day, you need to put in sufficient efforts to make a well-informed investment decision.

Remember the old adage — "What's obvious is obviously wrong."

Inverted reasoning and its consequences

In a classic, “ An Investor’s Anthology”, there is a brilliant piece by George Selden written in 1912.

“It is hard for the average man to oppose what appears to be the general drift of public opinion. In the stock market this is perhaps harder than elsewhere; for we all realize that the prices of stocks must, in the long run, be controlled by public opinion. The point we fail to remember is that public opinion in a speculative market is measured in dollars, not in population. One man controlling one million dollars has double the weight of five hundred men with one thousand dollars each. Dollars are the horsepower of the markets—the mere number of men does not signify.

This is why the great body of opinion appears to be bullish at the top and bearish at the bottom. The multitude of small traders must be, as a plain necessity, long when prices are at the top, and short or out of the market at the bottom. The very fact that they are long at the top shows that they have been supplied with stocks from some source.

Again, the man with one million dollars is a silent individual. The time when it was necessary for him to talk is past—his money now does the talking. But the one thousand men who have one thousand dollars each are conversational, fluent, verbose to the last degree.

It will be observed that the above course of reasoning leads up to the conclusion that most of those who talk about the market are more likely to be wrong than right, at least so far as speculative fluctuations are concerned. This is not complimentary to the “moulders of public opinion,” but most seasoned newspaper reader will agree that it is true. The daily press reflects, in a general way, the thoughts of the multitude, and in the stock market the multitude is necessarily, as a logical deduction from the facts of the case, likely to be bullish at high prices and bearish at low.

It has often been remarked that the average man is an optimist regarding his own enterprises and a pessimist regarding those of others. Certainly this is true of the professional trader in stocks. As a result of the reasoning outlined above, he come habitually to expect that nearly every one else will be wrong, but is, as a rule, confident that his own analysis of the situation will prove correct. He values the opinion of a few persons who he believes to be generally successful; but aside from these few, the greater the number of the bullish opinions he hears, the more doubtful he becomes about the wisdom of following the bull side.

This apparent contrariness of the market, although easily understood when its causes are analyzed, breeds in professional traders a peculiar sort of skepticism—leads them always to distrust the obvious and to apply a kind of inverted reasoning to almost all stock market problems. Often, in the minds of traders who are not naturally logical, this inverted reasoning assumes the most erratic and grotesque forms, and it accounts for many apparently absurd fluctuations in prices which are commonly charged to manipulation.

For example, a trader starts with this assumption: The market has had a good advance; all the small traders are bullish; somebody must have sold them stock which they are carrying; hence the big capitalists are probably sold out or short and ready for a reaction or perhaps for a bear market. Then if a strong item of bullish news comes out—one, let us say, that really makes an important change in the situation—he says, “Ah, so this is what they have been bulling the market on! It has been discounted by the previous rise.” Or he may say, “They are putting out this bull news to sell stocks on.” He proceeds to sell out any long stocks he may have or perhaps to sell short.

His reasoning may be correct or it may not; but at any rate his selling and that of others who reason in a similar way is likely to produce at least a temporary decline on the announcement of the good news. This decline looks absurd to the outsider and he falls back on the old explanation “All manipulation.”

The same principle is often carried further. You will find professional traders reasoning that favorable figures on the steel industry, for example, have been concocted to enable insiders to sell their steel; or that gloomy reports are put in circulation to facilitate accumulation. Hence they may act in direct opposition to the news and carry the market with them, for the time at least.

The less the trader knows about the fundamentals of the financial situation the more likely he is to be led astray in conclusions of this character. If he has confidence in the general strength of conditions, he may be ready to accept as genuine and natural a piece of news which he would otherwise receive with cynical skepticism and use as a basis for short sales. If he knows that fundamental conditions are unsound, he will not be so likely to interpret bad news as issued to assist in accumulation of stocks.

The same reasoning is applied to large purchases through brokers known to be associated with capitalists. In fact, in this case we often hear a double inversion, as it were. Such buying may impress the observer in three ways:

1. The “rank outsider” takes it a face value, as bullish.
2. A more experienced trader may say, “If they really wished to get the stocks they would not buy through their own brokers, but would endeavor to conceal their buying by scattering it among other houses.”
3. A still more suspicious professional may turn another mental somersault and say, “They are buying through their own brokers so as to throw us off the scent and make us think someone else is using their brokers as a blind.” By this double somersault such a trader arrives at the same conclusion as the outsider.

The reasoning of traders becomes even more complicated when large buying or selling is done openly by a big professional who is know to trade in and out for small profits. If he buys 50,000 shares, other traders are quite willing to sell to him and their opinion of the market is little influenced, simply because they know he may sell 50,000 the next day or even the next hour. For this reason great capitalists sometimes buy or sell through such big professional traders in order to execute their orders easily and without arousing suspicion. Hence the play of subtle intellects around big trading of this kind often becomes very elaborate.

It is to be noticed that this inverted reasoning is useful chiefly at the top or bottom of a movement, when distribution or accumulation is taking place on a large scale. A market which repeatedly refuses to respond to good news after a considerable advance is likely to be “full of stocks.” Likewise a market which will not go down on bad news is usually “bare of stock.”

Between the extremes will be found long stretches in which capitalists have very little cause to conceal their position. Having accumulated their lines as low as possible, they are then willing to be known as the leaders of the upward movement and have every reason to be perfectly open in their buying. This condition continues until they are ready to sell. Likewise, having sold as much as they desire, they have no reason to conceal their position further, even though a subsequent decline may run for months or a year.

It is during a long upward movement that the “lamb” makes money, because he accepts facts as facts, while the professional trader is often found fighting the advance and losing heavily because of the overdevelopment of cynicism and suspicion.

The successful trader eventually learns when to invert his natural mental processes and when to leave them in their usual position. Often he develops a sort of instinct which could scarcely be reduced to cold print. But in the hands of the tyro this form of reasoning is exceedingly dangerous, because it permits of putting an alternate construction on any event. Bull news either (1) is significant of a rising trend of prices, or (2) indicates that “they” are trying to make a market to sell on. Bad news may indicate either a genuinely bearish situation or a desire to accumulate stocks at low prices.

The inexperienced operator is therefore left very much at sea. He is playing with the professional’s edged tools and is likely to cut himself. Of what use is it for him to try to apply his reason to stock market conditions when every event may be doubly interpreted?

Indeed, it is doubtful if the professional’s distrust of the obvious is of must benefit to him in the long run. Most of us have met those deplorable mental wrecks, often found among the “chairwarmers” in brokers’ offices, whose thinking machinery seems to have become permanently demoralized as result of continued acrobatics. They are always seeking an “ulterior motive” is everything. They credit—or debit—Morgan and Rockefeller with the smallest and meanest trickery and ascribe to them the most awful duplicity in matters which those “high financiers” would not stoop to notice. The continual reversal of the mental engine sometimes deranges its mechanism.

Probably no better general rule can be laid down than the brief one, “Stick to common sense.” Maintain a balanced, receptive mind and avoid abstruse deductions. A few further suggestions may, however, be offered:

If you already have a position in the market, do not attempt to bolster up your failing faith by resorting to intellectual subtleties in the interpretation of obvious facts. If you are long or short of the market, you are not an unprejudiced judge, and you will be greatly tempted to put such an interpretation upon current events as will coincide with your preconceived opinion. It is hardly too much to say that this is the greatest obstacle to success. The least you can do is to avoid inverted reasoning in support of your own position.

After a prolonged advance, do not call inverted reasoning to your aid in order to prove that prices are going still higher; likewise after a big break do not let your bearish deductions become too complicated. Be suspicious of bull news at high prices, and of bear news at low prices.

Bear in mind that an item of news usually causes but one considerable movement of prices. If the movement takes place before the news comes out, as a result of rumors and expectations, then it is not likely to be repeated after the announcement is made; but if the movement of prices has not preceded, then the news contributes to the general strength or weakness of the situation and a movement of prices may follow.

CONFUSING THE PRESENT WITH

THE FUTURE-DISCOUNTING

It is axiomatic that inexperienced traders and investors, and indeed a majority of the more experienced as well, are continually trying to speculate on past events. Suppose, for example, railroad earnings as published are showing constant large increases in net. The novice reasons, “Increased earnings mean increased amounts applicable to the payment of dividends. Prices should rise. I will buy.”

Not at all. He should say, “Prices have risen to the extent represented by these increased earnings, unless this effect has been counterbalanced by other considerations. Now what next?”

It is a sort of automatic assumption of the human mind that present conditions will continue, and our whole scheme of life is necessarily based to a great degree on this assumption. When the price of wheat is high farmers increase their acreage because wheat-growing pays better; when it is low they plant less. I remember talking with a potato-raiser the above custom. When potatoes were low he had planted liberally; when high he had cut down his acreage—because he reasoned that other farmers would do just the opposite.

The average man is not blessed—or cursed, however you may look at it—with an analytical mind. We see “as through a glass darkly.” Our ideas are always enveloped in a haze and our reasoning powers work in a rut from which we find it painful if not impossible to escape. Many of our emotions and some of our acts are merely automatic responses to external stimuli. Wonderful as is the development of the human brain, it originated as an enlarged ganglion, and its first response is still practically that of the ganglion.

A simple illustration of this is found in the enmity we all feel toward the alarm clock which arouses us in the morning. We have carefully set and wound that alarm and if it failed to go off it would perhaps put us to serious inconvenience; yet we reward the faithful clock with anathemas.

When a subway train is delayed nine-tenths of the people waiting on the platform are anxiously craning their necks to see if it is coming, while many persons on it who are in danger of missing an engagement are holding themselves tense, apparently in the effort to help the train along. As a rule we apply more well-meant, but to a great extent ineffective, energy, physical or nervous, to the accomplishment of an object, than to analysis or calculation.

When it comes to so complicated a matter as the price of stocks, our haziness increases in proportion to the difficulty of the subject and out ignorance of it. From reading, observation and conversation we imbibe a miscellaneous assortment of ideas from which we conclude that the situation is bullish or bearish. The very form of the expression “the situation is bullish”—not “the situation will soon become bullish”—shows the extent to which we allow the present to obscure the future in the formation of our judgment.

Catch any trader and pin him down to it and he will readily admit that the logical moment for the highest prices is when the news after it comes out—if not at the moment, at any rate “on a reaction.”

Most coming events cast their shadows before, and it is on this that intelligent speculation must be based. The movement of prices in anticipation of such an event is called “discounting,” and this process of discounting is worthy of a little careful examination.

The first point to be borne in mind is that some events cannot be discounted, even by the supposed omniscience of the great banking interests—which is, in point of fact, more than half imaginary. The San Francisco earthquake is the standard example of an event which could not be foreseen and therefore could not be discounted; but an event does not have to be purely an “act of God” to be undiscountable. There can be no question that our great bankers have been as much in the dark in regard to some recent Supreme Court decisions as the smallest “piker” in the customer’s room of an odd-lot brokerage house.

If the effect of an event does not make itself felt before the event takes place, it must come after. In all discussion of discounting we must bear this fact in mind in order that our subject may not run away with us.

On the other hand, an event may sometimes be over-discounted. If the dividend rate on a stock is to be raised from four to five per cent, earnest bulls, with an eye to their own commitments, may spread rumors of six or seven per cent, so that the actual declaration of five per cent may be received as disappointing and cause a decline.

Generally speaking, every event which is under the control of capitalists associated with the property, or any financial condition which is subject to the management of combined banking interests, is likely to be pretty thoroughly discounted before it occurs. There is rarely any lack of capital to take advantage of a sure thing, even though it may be known in advance to only a few persons.

The extent to which future business conditions are known to “insiders” is, however, usually overestimated. So much depends, especially in America, upon the size of the crops, the temper of the people, and the policies adopted by leading politicians, that the future of business becomes a very complicated problem. No power can drive the American people. Any control over their action had to be exercised by cajolery or by devious and circuitous methods.

Moreover, public opinion is becoming more volatile and changeable year to year, owing to the quicker spread of information and the rapid multiplication of the reading public. One can easily imagine that some of our older financiers must be saying to themselves. “If I only had my present capital in 1870, or else had the conditions of 1870 to work on today!”

A fair idea of when the discounting process will be completed may usually be formed by studying conditions from every angle. The great question is, when will the buying or selling become most general and urgent? In 1970, for example, the safest and best time to buy the sound dividend-paying stocks was on the Monday following the bank statement with showed the greatest decrease in reserves. The market opened down several points under pressure of liquidation, and many standard issues never sold so low afterward. The simple explanation was that conditions had become so bad that they could not get any worse without utter ruin, which all parties must and did unite to prevent.

Likewise in the Presidential campaign of 1900, the lowest prices were made on Bryan’s nomination. Investors said at once, “He can’t be elected.” Therefore his nomination was the worst that could happen—the point of time where the political news became most intensely bearish. As the campaign developed his defeat became more and more certain, and prices continued to rise in accordance with the general economic and financial conditions of the period.

It is not the discounting of an event thus known in advance to capitalists that presents the greatest difficulties, but cases where considerable uncertainty exists, so that even the clearest mind and the most accurate information can result only in a balancing of probabilities, with the scale perhaps inclined to a greater or less degree in one direction or the other.

In some cases the uncertainty which precedes such an event is more depressing than the worst that can happen afterward. An example is a Supreme Court decision upon a previously undetermined public policy which has kept business men so much in the dark that they feared to go ahead with any important plans. This was the case at the time of the Northern Securities decision in 1904. “Big business” could easily enough adjust itself to either result. It was the uncertainty that was bearish. Hence the decision was practically discounted in advance, no matter what it might prove to be.

This was not true to the same extent of the Standard Oil and American Tobacco decisions of 1911, because those decisions were an earnest of more trouble to come. The decisions were greeted by a temporary spurt of activity, based on the theory that the removal of uncertainty was the important thing; but a sensational decline started soon after and was not checked until the announcement that the Government would prosecute the United States Steel Corporation. This was deemed the worst that could happen for some time to come, and was followed by a considerable advance.

More commonly, when an event is uncertain the market estimates the chances with considerable nicety. Each trader backs his own opinion, strongly if he feels confident, moderately if he still has a few doubts which he cannot down. The result of these opposing views may be stationary prices, or a market fluctuating nervously within a narrow range, or a movement in either direction, greater or smaller in proportion to the more or less emphatic preponderance of the buying or selling.

Of course it must always be remembered that it is dollars that count, not eh number of buyers or sellers. A few great capitalists having advance information which they regard as accurate may more than counterbalance thousands of small traders who hold an opposite opinion. In fact, this is the condition very frequently seen.

Even the operations of an individual investor usually have an effect on prices pretty accurately adjusted to his opinions. When be believes prices are low and everything favors an upward movement, he will strain his resources in order to accumulate as heavy a load of securities as he can carry. After a fair advance, if he sees the development of some factor which might cause a decline—though he doesn’t really believe it will—he thinks it wise to lighten his load somewhat and make sure of some of his accumulated profits. Later when he feels that prices are “high enough,” he is a liberal seller; and if some danger appears while the level of quoted values continues high, he “cleans house,” to be ready for whatever may come. Then if what he considers an unwarranted speculation carries prices still higher, he is very likely to sell a few hundred shares short by way of occupying his capital and his mind.

It is, however, the variation of opinion among different men that has the largest influence in making the market responsive to changing conditions. A development which causes one trader to lighten his line of stocks may be regarded as harmless or even beneficial by another, so that he maintains his position or perhaps buys more. Out of a worldwide mixture of varying ideas, personalities and information emerges the average level of prices—the true index number of investment conditions.

The necessary result of the above line of reasoning is that not only probabilities but even rather remote possibilities are reflected in the market. Hardly any event can happen of sufficient importance to attract general attention which some other process of reasoning cannot construe our old friend of the news columns to the effect that “the necessary a large volume of business,” may influence some red-blooded optimist to buy 100 Union, but the grouchy pessimist who has eaten too many doughnuts for breakfast will accept the statement as an evidence of the scarcity of real bull news and will likely enough sell 100 Union short on the strength of it.

It is overextended speculator who causes most of the fluctuations that look absurd to the sober observer. It does not take much to make a man buy when he is short of stocks “up to his neck.” A bit of news which he would regard as insignificant at any other time will then assume an exaggerated importance in his eyes. His fears increase in geometrical proportion to the size of his line of stocks. Likewise the overloaded bull may begin to “throw his stocks” on some absurd story of a war between Honduras and Roumania [sic], without even stopping to look up the geographical location of the countries involved.

Fluctuations based on absurdities are always relatively small. They are due to an exaggerated fear of what “the other fellow” may do. Personally, you do not fear a war between Honduras and Roumania; but may not the rumor be seized upon by the bears as an excuse for a raid? And you have too many stocks to be comfortable if such a break should occur. Moreover, even if the bears do not raid the market, will there not be a considerable number of persons who, like yourself, will fear such a raid, and will therefore lighten their load of stocks, thus causing some decline?

The professional trader, following this line of reasoning to the limit, eventually comes to base all his operations for short turns in the market not on the facts but on what he believes that facts will cause others to do—or more accurately, perhaps, on what he sees that the news is causing others to do; for such a trader is likely to keep his fingers constantly on the pulse of buying and selling as it throbs on the floor of the Exchange or as recorded on the tape.

The non-professional, however, will do well not to let his mind stray too far into the unknown territory of what others may do. Like the “They” theory of values, it is dangerous ground in that it leads toward the abdication of common sense; and after all, other may not prove to be such fools as we think they are. While the market is likely to discount even a possibility, the chances are very much against out being able to discount the possibility profitably.

In this matter of discounting, as in connection with most other stock market phenomena, the most useful hint that can be given is to avoid all efforts to reduce the movement of prices of rules, measures, or similarities and to analyze each case by itself. Historical parallels are likely to be misleading. Every situation is new, though usually composed of familiar elements. Each element must be weighed by itself and the probable result of the combination estimated. In most cases the problem is by no means impossible, but the student must learn to look into the future and to consider the present only as a guide to the future. Extreme prices will come at the time when the news is most emphatic and most widely disseminated. When the point is passed the question must always be, “What next?””

The Logic of the Stock Price - Sanjeev Pandiya

A stock price has many definitions. One of the most sophisticated definitions is that it values the forecasted free cash flows of a company. There are many financial models that try to capture this conceptual definition (e.g. EV/EBIDTA, EPSxP-E, Cash EPSxCash P-E).

The most popular among them is the discounted (free) cash flow (DCF) valuation. Mainly popularized by Mckinsey and some other strategic consultants, it sought to value 'free cash flows' (operating margins, net of investment in working capital and routine capex, after adjusting for the tax benefits of leverage) over the visible period (also called the explicit period). Mckinsey also imputed a terminal value, which assumes a steady growth rate going to infinity. This perpetually growing cash flow often created a terminal value, which accounted for up to 90 per cent of the enterprise value (EV) in a fast growing company There are problems with this model. It often arrives at valuations that are considered 'theoretical' by markets. My understanding is that the 'strategic' valuation that the DCF is prone to recommend (5 to 8 years) is simply too long for the market. The real reason why the market often undervalues a given cash flow is that it is simply too myopic.

That seems to have been the disconnect in the Tata-Corus deal. Phrases like 'winner's curse, 'arrogant acquisition' 'overpayment' and 'value destroying' have been used. The difference in perspective, I think, is purely over the visible forecasted period. Tata Steel's strategists are valuing the free cash flow over a longer competitive advantage period. This goes back to the Buffetian argument that the valuation of the stock should take into account not only the size and growth rate of a cash flow but also the competitive advantage period. This articulates a long-standing disagreement between the steel industry and the stock markets. The steel industry is a long gestation industry. The typical project (concept to free cash flow) is set up over most of the typical business (or interest rate/liquidity) cycle. Hence any steel company has to ride out a period of high liquidity and a cash crunch every time it sets up a greenfield capacity. Steelmen, therefore, are used to thinking in terms of a gestation period of 8 to 12 years. They simply have longer visibility than the financial markets.

On the flip side, they also know that an embedded player has a huge advantage. Sometimes you make extra money simply because you are sitting there. The Tatas have possibly projected a certain free cash flow grown at certain rate over a longer competitive advantage period than the markets are used to defining.

So who is right? Financial market players (my mental stereotype is of the Ketan Parekhs, Harshad Mehtas and the hedge funds of the world) or the steel industrialists? Are these market players any richer than the Tatas? Long-term investors don't necessarily do worse than spectacular wealth creators, found so commonly in the financial markets. You just have to decide what you want to be.

When Warren Buffet said, “Buy the business, not the scrip”, this was what he meant. Let me explain this in detail.

I don't think too many people, bar the most cynical, are arguing that the Tata-Corus deal is going to reduce the total free cash flow (FCF) of the combined entity. Yes, there is a certain view that if the steel cycle turns, the FCF being projected will drop, but will it turn negative? And if it doesn't, then the payback will happen. Only the rate at which the payback will happen might get extended. That would increase the number of years taken to digest the acquisition.

This is what a value investor should seek. Whenever Mr Market turns apoplectic, but you find long-term, 'strategic' players who want to 'buy the business, not the scrip' on your side; go ahead, jump. This is the Buffet model. Once you know where the market stands, you should stand apart from the market. At this point in time, the broader market is definitely morose about Tata Steel. Yet, nobody is arguing with Mr Ratan Tata on his claims of “long-term value”. The difference of opinion is only about the investment horizon.

Most of my regular readers would know that I am usually bearish, skeptical, 'negative'. This is especially true of the last couple of years, when I have been negative, even as I have myself joined the large mass of India's nouveau riche. Well, here is my recommendation - buy Tata Steel, and keep trading in the stock for five years (which is the payback period estimated by many analysts on current cash flows of the combined entity).

How do you trade? As you find the short-term (Mr. Market) marketmen get out, pace yourself and get in. Just like you buy a systematic investment plan (SIP), keep buying this stock on declines. Every time the stock recovers back to its previous high, sell what you bought at lower levels; then buy back the stock as it declines. This way, target to keep your average holding cost lower than the prevailing stock price. The stock will make a long, saucer-like pattern. Your average holding cost should track the falling price of the stock. As your average price drops, keep adding to your total holding. In other words, take your trading profits in the form of stock, not cash.

I will not speculate on how long the coming (down cycle?) will continue. The RBI has just hiked CRR rates again, clearly telling the country that they are determined to squeeze out liquidity till inflation slows down. As interest rates rise, the cost of capital in the markets will rise much more. That should bring temperance to the stock markets (and real estate, but that is a different story).

If you don't know how to trade, then you must buy and hold. That is a more difficult way to earn money, but Warren Buffet has proved that it can be equally profitable. For buy-and-hold investors, this would still count as a 'Buffet event', i.e., a sharp, apparently disastrous incident that looks spectacular, but does not impact the long-term prospects of the company. That is a cue for value investors to go bottom-fishing.

Investors and Scientists - Chetan Parikh

In a great book, "The only three questions that count", the author, Ken Fisher, writes about investing and scientific inquiry.

“When I was a kid, if you wanted to be a scientist they made you take Latin or Greek. I was a good student generally and took Latin not because I wanted to be a scientist—I didn’t—but because I couldn’t figure out the benefit of my other options, Spanish or French. Since no one speaks Latin, I forgot almost everything immediately thereafter, except the life lessons in which Latin abounds—like Caesar distinguishing himself by leading from the front of his troops, not the rear as most generals did (and do). It’s maybe the most important single lesson of leadership.

Another lesson: The word science derives from the Latin scio—to know, understand, to know how to do. Any scientist will tell you science isn’t a craft; rather, it’s a never-ending query session aimed at knowing. Scientists didn’t wake up one day and decide to create an equation demonstrating the force exerted on all earthly objects. Instead, Newton first asked a simple question like, “I wonder what the heck makes stuff fall down?” Galileo wasn’t excommunicated and immortalized for agreeing with Aristotle. He asked, “What if stars don’t work like everyone says? Wouldn’t that be nuts?” Most of us would see the best scientists of all time, if we could meet them face-to-face, as maybe nuts. My friend Stephen Sillett, today’s leading redwood scientist, changed the way scientists think about old growth redwoods and trees in general by shooting arrows with fishing lines tied to them over the tops of 350-foot-tall giants, tying on a firmer line, and free-climbing to the tops. He found life forms and structures up there no one ever knew existed. Dangling off those ropes 350 feet from terra firma is nuts. Nuts! But he asked the questions: What if there is stuff in the very tops of standing trees that isn’t there when you cut them down? And if there is, would it tell you anything about the trees? In the process, he discovered much no one had ever known existed. Why am I telling you this?

Because most of what there is to know about investing doesn’t exist yet and is subject to scientific inquiry and discovery. It isn’t in a book and isn’t finite. We just don’t know it yet. We know more about how capital markets work than we did 50 years ago, but little compared to what we can know in 10, 30 and 50 years. Contrary to what the pundits and professionals will have you believe, the study of capital markets is both an art and a science—one in which theories and formulas continually evolve and are added and adjusted. We are at the beginning of a process of inquiry and discovery, not the end. Its scientific aspect is very much in its infancy.

Scientific inquiry offers opportunities ahead as we steadily learn more about how markets work than we ever imagined we could know previously. What’s more, anyone can learn things now that no one knows but in a few decades will be general knowledge. Building new knowledge of how capital markets work is everyone’s job, whether you accept that or not. You’re part of it, whether you know it or not. By knowingly embracing it you can know things others don’t—things finance professors don’t know yet. You needn’t be a finance professor or have any kind of background in finance to do it. To know things others don’t, you just need to think like a scientist—think freshly and be curious and open.

As a scientist, you should approach investing not with a rule set, but with an open, inquisitive mind. Like any good scientist, you must learn to ask questions. Your questions will help you develop hypotheses you can test for efficacy. In the course of your scientific inquiry, if you don’t get good answers to your questions, it’s better to be passive than make an actionable mistake. But merely asking questions won’t, by itself, help you beat the markets. The questions must be the right ones leading to an action on which a bet can be made correctly.”

Cutting losses

Is the first loss the smallest? How important is it to learn to take losses quickly and cleanly? In a great book “Hedge Hogging”, the author, Barton Biggs, writes about the importance of cutting losses.

“Greg is very tough about cold-bloodedly reviewing his losses. Like many traders, he does it automatically, usually at the 10% loss level. Roy Neuberger, Gerald Loeb, Bernard Baruch, and Jesse Livermore all did it. Baruch had an ego that would have fit comfortably into the Temple of Dendur, but he was an astute investor. In his book My Own Story he tells how he learned the hard way to cut his losses by selling when a po­sition went against him. He wrote:

In the stock market the first loss is usually the smallest. One of the worst mistakes anyone can make is to hold on blindly and rifuse to ad­mit that his judgment has been wrong. Occasionally one is too close to a stock. In such cases the more one knows about a subject, the more likely one is to believe he can outwit the workings of supply and demand. Experts will step in where even fools fear to tread.

Baruch argues one should always buy on a scales-up.

Many a novice will sell something he has a profit in to protect some­thing in which he has a loss. Since the good position has usually gone down the least, or may even show a profit, it is psychologically easy to let it go. With a bad stock the loss is likely to be heavy, and the impulse is to hold on to it in order to recover what has been lost. Actually the procedure one should follow is to sell the bad position and keep the good position.

Baruch wrote that one of his most important rules of investing was to "learn how to take your losses quickly and cleanly."

In Reminiscences of a Stock Operator by Edwin Lefevre, Jesse Liver­more says over and over again that you should buy on a scale-up and sell on a scale-down. "Never make a second transaction in a stock," he writes, "unless the first shows you a profit. Always sell what shows you a loss. Only suckers buy on declines."

Livermore did not have a hard-and-fast rule on when to eliminate a losing position, arguing instead that the timing depends on the feel of the stock and the market. However, he was an unusually gifted, intuitive trader, and he was not burdened by much knowledge of the fundamentals of the positions he took. Thus Livermore was more flexible in his think­ing than most of us who probably overintellectualize our stocks, and he was a dedicated believer in owning strong stocks that were in clearly de­fined, long-term up-trends. As soon as a stock he was long faltered, he got rid of it. His rule was that when a stock that had been strong failed to rally after a reaction, that was the first sign of trouble and time to get out.

Of course, buying strength and selling weakness is pure momentum investing, and as a value investor and believer in the inherent efficacy of fundamental analysis, I disdain that style. So does Warren Buffett. He has said that he doesn't believe in stop-loss disciplines. Nevertheless, you have to be respectful of the knowledge of the market. If a position goes against you by 10%, maybe somebody has understood something you have missed. When a position declines by 10%, we force ourselves to do an extensive and systematic review of the fundamentals with both inter­nal and external resources. We have to be sure nothing has changed. After the review, if nothing has changed except the price of the stock, we have to buy more. If we lack that conviction, we have to sell at least half of the position.

A trend is a trend is a trend
But the question is, will it bend?
Will it alter its course
Through some unforeseen force
And come to a premature end. . . ?

-Sir Alec Cairncross, Chief Economic Adviser

to the British Government in the 1960s”"

Busting the Small Investor Myth - By Dhirendra Kumar

There seems to be a school of thought around that the stock markets must run in such a way that the so-called retail investor must always make money and if he doesn't, then there's something wrong. Either the laws are inadequate or the markets are crooked, or preferably, both. This belief surfaces most strongly whenever an IPO opens at a discount, as happened with Cairn Energy. The belief that the retail investor (formerly called the small investor) has a right to make profits no matter what he does is shared by some in the investment community, the media and in the government. There are frequent lamentations about the fact that the retail investor is not participating in the markets and various remedies are suggested (and some implemented) to correct this supposed anomaly. In fact, 2005's IPO scam was essentially about large investors going to absurd lengths to disguise themselves as small investors in response to the IPO lottery being fixed to favour the latter.

Am I saying that no individual should invest directly in stocks at all? After all, expert investors too start out as individuals investing for themselves. The way it happens is that a large number of investors try their hand at the markets, usually when the markets are booming. As long as the markets stay strong they all make money, more or less. This makes them confident so that when the bulls stop running, most of them lose heavily. Some, however, turn out to have the right mental make-up for this activity and go on to become experts. There is nothing wrong with this. Markets are inherently Darwinian and it is in their nature that those who make the wrong choices will lose. For a market to function correctly, those who make the right choices must make money those who make the wrong choices must bear losses. If we see this as a problem and try and fix things, we will actually end up breaking them.

I think this idea of the small investor participating directly in the stock markets needs to be fundamentally re-examined. Trading profitably in stocks on a sustained basis is a specialized skill that is not easy to acquire or practice. This has always been true in all stock markets regardless of whether those markets are well-regulated or not or whether they are crookedly organised or honest. Those who promote the idea that everyone can buy and sell shares and make money with any certainty basically end up leading a lot of lambs to eventual slaughter. For the small investor, the only safe way of participating in the markets is indirectly, through a mutual fund or some similar structure where their money is being managed by someone else who has a good track record that is transparently known.

Stock investing is an increasingly complex activity. At a time when Indian business are evolving so rapidly, the kind of commitment of time and effort needed to research things adequately can probably not be made on an part-time basis. I'm not saying that no one can do this but being an informed investor takes either a professional-scale commitment or an accidental instinct. There's no guarantee that any given investor can do this. It's time to lay the myth of the small investor to rest.

Revisiting the IPO scene

Buoyed by the bull phase and an unrelenting appreciation in stock prices in the preceding two years, the IPO (initial public offering) market has been quite active in 2005-06, with several big names raising funds through this route. Not only did this list include some high-profile companies such as Jet Airways, Shopper's Stop, Suzlon Energy and Reliance Petroleum, it also featured stock market debuts by some unconventional companies in new businesses such as multiplexes, aviation and broadcasting, hitherto unrepresented on the stock market. Business Line made recommendations on 100 of these IPOs between January 2005 and June 2006. We revisit some of these companies for a report on where investors in these IPOs now stand and evaluate whether these new entrants still merit investment.

Investors would be sitting pretty had they invested in our `invest' recommendations, which generated an average return of about 80 per cent. Celebrity Fashions and Jet Airways, however, have not performed as well as expected.

Heightened business risks due to events that played out after the IPO appear to have contributed to the poor performance of these stocks. The number of IPOs rated `Avoid' was 44. These stocks, on an average, generated an unimpressive 2 per cent return till date.

A significant number of IPOs rated `Invest' quote at about twice their offer price. Our `Avoid' list has also panned out well, with a few stocks quoting at a 40 per cent discount to the offer price. Here, we attempt to follow up our initial recommendations in some of these stocks, with an emphasis on scrips that have registered the most and least gains from their IPO price.

Bombay Rayon: Phase-out of the quota system in global trade along with the government-sponsored TUFS loans has driven capacity expansion in the textile industry.

Buoyed by a bull phase in the secondary market, a significant number of companies in this sector tapped the primary market. Bombay Rayon, which made its debut in December 2005, was among our top picks in the textiles space. Within the space of a year the stock trades at Rs 210 against Rs 70 (the invest price). The sharp deprecation has not altered our view that investors would be better off exiting this stock, as valuations appear stretched. It trades at a premium to similar-sized peers in the textile industry. The company is on an expansion binge, though revenue from these plans is likely to flow in only in the medium term given the order backlog in the textile machinery industry. An equity dilution, which appears to be on the cards, is a dampener.

SPL Industries: Buoyed by the response in the primary market to Gokaldas Exports and opportunities in the global markets, SPL Industries, in July 2005, offered 90 lakh shares at Rs 70 apiece. Despite the stock trading at a significant discount to its offer price, we continue to be bearish. At Rs 40, the stock trades at about nine times its trailing twelve-month earnings. Though valuations appear moderate, earnings prospects remain uncertain. While its export potential remains intact, SPL Industries faces competition from larger peers. SPL's margins, which are thin, have come under further pressure in recent quarters. Larger integrated players are our preferred picks in the textile sector.

Uttam Sugar: Rated `Avoid', this is a stock in which IPO investors have lost significant value. Offered at Rs 340 per share in March 2006, it now trades at about Rs 140. The sharp decline in the stock, however, has not materially altered our overall view on it.

Uttam Sugar, an integrated player in the sugar business, tapped the market to fund its greenfield expansion plans. The lifting of the export ban on sugar and commencement of production at its 4,500 tcd facility at Khaikheri augur well for revenue growth. However, the earnings growth for sugar companies may slow from the scorching pace of the past, given the weak trends in domestic and international sugar prices.

Intense competition for cane procurement in Western UP is an added risk. Under the circumstances, it may be better to restrict stock exposures in the sugar sector to one or two frontline players.

Sadbhav Engineering: An infrastructure player focussed on road projects, Sadbhav Engineering has registered a two-fold rise on its offer price. With the company riding on a comfortable order-book position in the road construction business, we continue to retain a positive view. Sadbhav, however, faces intense competition in the road segment from larger peers.

A ramp-up in its capital base, which is about Rs 130 crore, would be required for Sadbhav to leap into larger projects. However, with Gammon holding a sizeable minority stake in Sadbhav, order-flows from this larger peer are likely to fast-track revenue growth. Mining operations and irrigation projects are also among the company's focus areas. Diversi- fication is key for the company to break away from the low-margin highway business.

Sasken: The fundamentals of Sasken, a hybrid telecom products-cum-services play, rest on a strong footing. Our positive outlook on the stock stems from the strong demand for offshore R&D services — going by the R&D spend by telecom equipment majors, its blue-chip clientele — the broad range of service offerings and recent acquisition of Finland-based Botnia. The upside in the stock is likely to come from the ramp-up in product revenues, which is not fully factored into its current valuation. We reiterate an `invest' on the stock recommended in April at Rs 352 and suggest investors stay invested at current price levels.

3i Infotech: A strong third-quarter performance, with robust growth in revenues and swelling order-book, sustained acquisition spree of small sized companies and evenly-spread revenues from different geographies, continue to inspire confidence in the 3i Infotech stock.

The downside risks stem from slowdown in discretionary spends in the banking domain and heightened competition affecting growth prospects and putting pressure on margins. In the latest quarter, the company also revised its earlier policy of capitalising its software development costs by charging software product development costs as incurred through the profit and loss account. We have an outstanding `buy' recommendation on this stock made in August at Rs 169 and now recommend a `hold'.