Economic moat of a company

Economic moat of a company

How can investors be 100% sure of not losing their capital despite investing in the equity market?

The first step in identifying the right set of companies is to understand ‘what they bring to the table’. You don’t want to be investing in companies whose strategies and products can easily be replicated by competitors.

Economic Moat

In 2007 Berkshire Hathaway letter to shareholders, Warren Buffet gave ‘economic moat’ concept to the world.

Just like a castle has a moat that surrounds the castle with muddy water, crocodiles etc. This moat prevents enemies to enter the castle. Similarly, economic moat represents some sort of protection of business cash flows.

Businesses with economic moats have sustainability.

A competitive advantage is an advantage that currently allows a company to earn premium margins over its competitors. But an economic moat is a sustainable competitive advantage–a competitive advantage that will last.

Here are few “symptoms” to help us identify economic moat:

Intangible assets: Fanatically loyal customers. Profit margins or cash returns on invested capital that consistently exceed the industry average or those of their competitors. Successful companies with high priced, quality products or services for decades, supported by their brand strength.

Customer Switching Costs: Products and services that are not easily abandoned for a substitute or for a competitor’s product.

Networks Effect: Networks that become more useful as more people join.

Example: Colgate India

One way to understand whether a company has an economic moat is to look at financial reports of the last 10 years. High return on capital employed with high growth in sales and profit will indicate economic moat of a company.

Colgate India manufactures and markets oral care products and other toiletries in India since 1937 and has demonstrated high returns (ROCE) and cash flow generation (Growth) over the years.

They have large established brand and distribution network in place. The company spends 15-16% of revenue each year for marketing (protecting the moat).

Toothpaste is one of the first things that someone puts in his or her mouth in morning. Hence, there is switching cost (psychological) if someone wishes to switch their toothpaste.

So does that mean, you go ahead and invest in this company – “NO”

Price is what you pay and value is what you get. You will wait for the price to be in the range where you get maximum value. This is where valuation comes in or what we call as knowing the fair worth of the company/intrinsic value.

There is a lot of literature on DCF based valuation but that value may be speculative. A conservative approach to understanding the fair value of a company is to compare its asset value with earning power value.

Time tested stock investing approach

Time-tested stock investing approach

Ben Graham in 1940 recommended having ‘margin of safety’ while investing in stocks. This approach was practised by many investors including Warren Buffet and it surely worked.

The company’s worth is roughly equal to asset’s worth less any liabilities.

But what about growth and profitability? This class of investors often don’t like paying for future growth but are comfortable paying for asset value and current earnings (Earning Power Value). Let’s just focus on asset value approach for now.

Value based on Assets 

Any company’s value can simply be its asset value. Well, this is the first level of assessment that can represent the baseline of company’s value.  

Any company has two kinds of assets i.e. current and fixed. Most of the current assets represent its fair worth in the balance sheet. However, fixed assets have to be assessed since the likelihood of fixed assets value in the balance sheet is low. For example, land bought fifteen years back will be worth lot more than what is mentioned in the current balance sheet. 

There are two ways to look at a company’s asset value: liquidation value or reproduction value. 

Liquidation value

This is the value assuming the company is closing down. The analyst maybe trying to assess whether to buy distressed debt or equity. 

Here is a sample balance sheet to assess liquidation value: 

Sample balance sheet

Assets

2018

2017

Current assets

 

 

Cash

150

145

Marketable securities

25

70

Accounts receivable

1667

1525

Inventories

2329

2250

Total current assets

4170

3990

 

 

 

Plant, property and equipment

7500

7750

Goodwill

2250

2400

Deferred taxes

150

155

Total assets

14070

14295

 

 

 

Liabilities and equity

 

 

Current liabilities

 

 

Notes payable

2200

0

Accounts payable

1417

850

Accrued expenses

1250

725

Current portion of long term debt

9500

9250

Total current liabilities

5387

2075

Long term debt

9500

9250

Deferred taxes

125

150

Preferred stock

350

350

Paid-in capital

850

850

Retained earnings

(2141)

1620

Total liabilities and equity

14070

14295

Let’s deep dive


Cash and marketable securities are taken as mentioned in the balance sheet.

Account receivable will probably not be recovered in full, but since it is trading debt, we can estimate that we can realize 85% of the stated amount.

Inventory valuation depends upon the type of inventories, more specialized inventory will fetch lower amount.

The same logic applies to plant, property and equipment as well. I have assumed 50% inventory realization and 45% plant, property and equipment realization.

Goodwill will not fetch anything and deferred taxes will get adjusted to the liabilities.

Assets

2018

Percentage realized

Value

Current assets

 

 

 

Cash

150

100

150

Marketable securities

25

100

25

Accounts receivable

1667

85

1417

Inventories

2329

50

1164

Total current assets

4170

 

2756

Plant, property and equipment

7500

45

3375

Goodwill

2250

0

0

Deferred taxes

150

0

0

Total assets

14070

 

6131


Account payable and accrued expenses amount to only 2,667. After paying for these liabilities 12,220 will still be left as liabilities.

Given the condition of the company, if a steep discount is available on debt, investing in this is not a bad option. Stock investing in this company may not make sense. 

Reproduction value

If a company operates in a viable industry then the economic value of the assets is their reproduction cost i.e. what a competitor has to spend in order to get into this business.

Current assets

Cash and marketable securities do not require any adjustment. A new company starting out may not be as effective in getting the payments from the customer. Therefore, adjusting for allowances in accounts receivable is a better idea.

Valuing inventory can be a daunting exercise. Based on the industry, the analysis needs to be performed especially inventory / COGS to understand if there is any pilling up of inventory.

Additionally, if the firm uses LIFO method of inventory reporting, LIFO reserve should be added back because the new firm may not be able to source inventory at last years price.

Fixed assets

Plant, property and equipment may be shown as one item but they are actually three. Land usually appreciates; assessing the market value of the land is a better idea.

Plant and building use depreciation allowance that may not represent the true picture. The competitor has to pay lot more than what is usually shown on the balance sheet.

The adjustment made in the equipment value may be up or down, depending on the industry but it is not so massive.

Value of goodwill needs to be understood rather than relying on the balance sheet number. Goodwill is an accounting entry but a company may enjoy premium due to its reputation.

Goodwill may be linked to R&D and marketing expense of the company. You should be able to answer “How many years will the product take to establish its market?” if the new company were to enter the industry. 

Adjustment required arriving at reproduction costs

Assets

Adjustment required arriving at reproduction costs

Current assets

 

Cash

None

Marketable securities

None

Accounts receivable

Add bad debt allowance; adjust for collections

Inventories

Add last in, first out reserve, if any; adjust for turnover; watch out for changing ratio of inventory/COGS

Prepaid expenses

None

Deferred taxes

Discount at present value

Plant, property and equipment

Original cost plus adjustment; land usually gets a premium and equipment/plant have to be discounted

Goodwill

Relate to product portfolio and R&D and marketing

Asset value needs to be compared with earning power value (EPV)

If you are up to dig into annual reports for the last ten years, EPV can help you find great opportunities.

Well, enough for now, EPV for some other day!

When is a good time to invest?

When is a good time to invest?

When the markets are high, people are concerned. When the markets are low, people are concerned.

IS IT A GOOD TIME TO INVEST OR SHALL I WAIT

– Investors always ask this question.

As a young student of finance more than 15 years back, I always wanted to know an answer to this question.

How does share price emerge?

This is an underlying thought of whether this is a good time to invest or not.

In quest of answering this question, I started reading books on investing. Fortunately, came across a book “Intelligent Investor” by Benjamin Graham.

This line in the book answered my question and changed my perspective on the stock market:

“In the short run, a market is a voting machine but in the long run, it is a weighing machine.”

In the short-term, mood of the market defines where the prices would be going. However, in the long-term, company’s performance defines the performance of share price.

Can there be an analytical tool to assess the market mood?

Let us look at how you can assess the current mood of the market. This factor does not predict the future but focuses more on the present state i.e. whether the market is over or under-bought.

Earning yield + Dividend yield – 10 years government yield

A positive number indicates that market is undervalued; else, you are better off in bond investing. At any point in time, the portfolio may be maximum 75% in equity and minimum 25% in equity.

If you would have followed this strategy for the last 18 years, using purely 10-year government bond yield and Nifty 500 index, the return would have been 15% per annum. Except 2008, for all the rest of the past 18 years, the return was positive. This way you can plan your portfolio better and manage your investment psychology better.

The analysis indicates that current market is overvalued, finding investment opportunities may be a challenge and you are better off parking majority of your investments in bonds.

Here are the investment rules I follow in my firm:

1. Assess the market using the analysis provided above. I use NSE500 as a proxy for equity, dividend yield as 1.57% and current 10-year government bond yield.

2. When my model indicates +2% factor, perform fundamental analysis on selected companies that are deeply discounted. This touches upon the long-term view, “market as weighing machine” analogy.

Where do you find deeply discounted value? A company that is fundamentally strong but has a lot of negative news around it. 52 weeks low is more relevant than 52 weeks high 🙂

3. If the factor is less than 2%, a combination of ETFs, short-term debt funds and a mutual fund may be used. Finding deeply discounted equity is a challenge in this zone.

I like sitting on cash i.e. being invested in bonds if I do not see any opportunity in the equity market. I do not like chasing returns; I like managing my risk better.

Please stay away from people who tell you that they will chase a certain return for you.

No one in the world can predict where the equity markets will go. However, smart investors always know that they can always manage their risk better and returns are generated over a period of time.

The consistency of return while managing portfolio risk is more important than high returns during bull-run.

Interestingly, print and TV news focuses on figuring out the short-term view of the market. There are not many options to get information without opinions. You will be better if you do not read or watch at all than getting opinionated about the markets.

Just keep it simple and manage your portfolio peacefully so that you do not lose sleep!

Tax Savings and how you can save taxes legally ?

Tax Savings and how you can save taxes legally?

There are various legal ways to save taxes in India, yet a lot of people don’t take advantage of tax saving benefits.

Listed below are some options you can explore.

1.) Saving taxes under sections 80C, 80CCC and 80CCD

To promote the culture of savings the Income Tax Department provides various incentives to taxpayers in India. If a taxpayer invests in financial instruments as specified under sections 80C, 80CCC and 80CCD, then the taxpayer can claim a deduction for those investments from their taxable income.

The maximum deduction allowed under these sections is Rs 1,50,000 per year.

This means that if you invest Rs 1.5 lacs in the instruments as specified in u/s 80C, 80CCC and 80CCD, you can save between Rs 7,500 to Rs 45000 per year depending upon your income tax bracket.

Example: Let’s assume an individual’s income is Rs 5 lakhs. There is a standard deduction of Rs 2.5 lakhs so your effective taxable income is Rs 2.5 lakhs.

If you don’t make any tax saving investments, you are liable to pay tax on the entire taxable income of Rs 2.5 lakhs. At 5% tax rate, you will pay taxes of Rs 12,500.

If you invest Rs 1.5 lakhs, then your net taxable income now reduces from Rs 2.5 lakhs to just 1 lakhs. Now, you are liable to pay tax only on Rs 1 lakhs. At 5% tax rate, you will now pay a tax of Rs 5,000.

This has two advantages:

  1. You have saved Rs 7,500 in taxes.
  2. You also have a forced savings of Rs 1.5 lakhs, which will grow in the future.

There are many investment options, which are specified by the Income Tax Department that can be used to claim this deduction.

Here is a list of most popular ones:

  • Public provident fund (PPF)
  • 5-year tax saving fixed deposit
  • Equity-linked savings scheme (ELSS)
  • Contribution to employee provident fund (PF)
  • Pension plans
  • National savings certificate (NSC)
  • Insurance policy premium payments
  • Principal repayment for a home loan

You should ideally allocate these investments for your retirement. Mostly, people make tax saving investments in PPF/NSC/PF and think that their future is secure.

These investments are only to cover inflation and will never grow your wealth in real terms.

Therefore, you can also add growth-oriented assets such as Equity oriented mutual funds (ELSS).

Additionally, you can plan to invest Rs 50,000 per year in NPS that can provide you with a tax benefit over and over Rs 1.5 lakh limit. So effectively, you can reduce Rs 2 lakhs in total if you exhaust Sec 80C limit and invest more than Rs 50,000 in NPS.

2.) Saving taxes under sections 80D, 80DD, 80DDB Section 80D

The income tax department allows you to save taxes if you have purchased a health insurance policy. A deduction is available up to a limit of Rs. 25,000 p.a. for insurance of self, spouse and dependent children. If individual or spouse is more than 60 years old the deduction available is Rs 30,000.

An additional deduction for insurance of parents (father or mother or both) is available to the extent of Rs. 30,000.

Section 80DD

You can claim up to Rs 75,000 for expenses incurred on medical treatment of your dependents (spouse, parents, kids or siblings) if they have 40% + disability.

Section 80DDB

An individual (less than 60 years of age) can claim up to Rs 40,000 for the treatment of specified critical ailments. This can also be claimed on behalf of the dependents. The tax deduction limit under this section for senior citizens is proposed as Rs 60,000 and for very Senior Citizens (above 80 years) the limit is Rs 80,000.

3.) Saving Taxes via a home loan

You can claim up to Rs 2 lakhs as a tax deduction on the interest component of your home loan EMI repayments every year if you are residing on the same property.

If your property has been rented, then the entire interest component payable for the year can be claimed as a tax deduction.

Additionally, principal payment on a home loan is covered under section 80C.

4.) Saving Taxes via an education loan

If you have taken an education loan, any interest payment towards the loan qualifies for a deduction u/s 80E.

This loan is taken for higher education for the assessee, spouse or children or for a student for whom the assessee is a legal guardian.

5.) Saving taxes via long-term capital gains from the sale of a house

Any long-term capital gains, made by selling primary property is eligible for exemption of capital gains tax if the incremental amount is invested in specific tax saving investments (like tax saving infrastructure bonds etc.).

Any asset is considered as a long-term capital asset if the taxpayer holds that asset for more than 2 years.

Let’s assume you bought a house for Rs 50 lakhs and sold it 5 years later for Rs 1 crore. You are liable to pay long-term capital gains on the profit you have made i.e. 50 lakhs.

However, if you invest the Rs 50 lakhs in tax saving infrastructure bonds, then you will be exempted from paying capital gains tax. 

6.) Saving Taxes via long-term capital gains from the sale of shares

You pay 10% long-term capital gain tax if the shares or equity mutual funds are sold after one year.

If the shares or equity mutual fund units are sold within a year from purchase date, short-term capital gain tax at 15% will be applicable.

So if you bought shares or mutual funds worth Rs 60 lakhs, which increase in value to Rs 1 crore after a year, you will not be liable to pay 10% tax on the profit of Rs 40 lakhs i.e. Rs 4 lakh.

NOTE: The deductions and tax rates mentioned above are applicable for the financial year 2018-2019 and usually change from year to year.

Great, now that you have discovered six ways to save tax legally, here are six incomes that you shouldn’t forget to declare.

1.) Interest earned from savings bank account

This interest is tax-free up to Rs. 10,000. Any interest earned above that is taxable and should be declared.

2.) Interest earned from fixed deposits/recurring deposits

This is taxable as per one’s income tax slab. Banks will deduct 10% as TDS when the interest accrued is more than Rs. 10,000 (unless one submits Form 15 G/H).

However, the actual tax liability will probably be more or less, depending upon the tax bracket of an individual.

3.) Cash gifts

Cash gifts of over Rs. 50,000 should be declared as they are taxable (unless for specific occasions like marriage).

4.) Capital gains/losses

Any capital gains/losses made from trading equities, selling mutual funds, gold, etc. should be declared even though they may be nontaxable (e.g. ULIPs, the long-term capital tax is nil). Similarly, any losses should be declared as these help in offsetting gains for subsequent years.

5.) Exempt income

Exempt income (e.g. interest earned on PPF/EPF accounts) should be declared for auditing purposes only. This is a tax-free income.

6.) Dividend income

Dividend income from equity stock holdings or mutual funds is tax-free in the hands of the investor. However, this should be declared while filing income tax returns.

Generally, many individuals who are employed will get a Form 16 from their employer, which is usually sufficient for filing your income tax returns. However, if you have income from the above 6 sources, you should declare that to your CA so that your returns can be correctly filed.

If you don’t declare an income and the IT department initiates a scrutiny against you and discovers it, you may be liable to pay a penalty.

 

Why Indians need financial advisors?

Why Indians need financial advisors?

“I want a risk free investment option that gives me a good return”

Well, this is what we often hear from clients.

Risk and return

Most Indians do not understand the correlation between risk and return. Everyone wants a high return without assuming any short-term volatility. There is a direct relationship between risk and return. If you want a high return, there will be high risk (volatility) in the short-term. This is the reason linking return with time horizon or goals makes complete sense.

Capital protection

Why should anyone lose money, after all, it’s your hard-earned money? However, it’s equally important to know that short-term volatility has no bearing on long-term returns. We should delink associating short-term volatility with investment risk.

Laid back attitude

How much you earn has nothing to do with how much wealth you accumulate. Often ‘being rich’ is attributed to ‘he must have done something wrong, that’s why he has money’. Making money in life is all about attitude. This is precisely the reason everyone from IIT/IIM is not a millionaire. And those who are, may not be cheats!

Bias towards physical assets

Something that you touch and feel gives you a sense that you own it and probably you can show to others. That’s why the love for gold and real estate. These are also asset classes that have their own return cycles. For the last few years, both of these classes have not delivered great returns to the investor. These may be part of the portfolio, but not all of it.

Saving versus investment

A lot of people feel that they are saving enough without realising that money lying in their savings account is not an investment. You need to take corrective action in diverting those funds in right financial instruments so that your saved money grows well beyond inflation.

Financially illiterate

Understand ‘time value of money’ concept is critical. Often, we do not understand that growth in wealth is a long-term phenomenon. We either get involved in trading for short-term gains (turns into losses though) or don’t invest for long-term at all.

The language of products

In India, people are more comfortable talking in the language of investment products rather than their own requirements. This is precisely the reason that you get enticed by an insurance agent to buy an insurance product that delivers less than 5% return (ULIPs, endowment, LIC policies etc.). A better approach should be to reflect on your needs and accordingly evaluate investment products.

Advice for free

Everyone wants advice for free. If you fall ill, you always have a choice to buy over the counter medicine from a pharmacist or consult a doctor. Although the trend is changing, still a majority of Indians think that they get quality advice without paying anything.

Media knows

How will equity market perform in 2018? All the investment news channels forecast how will be the next year. Isn’t that speculative and not investing. Additionally, most of the retail investors would apply for IPOs to make listing gains. Think about it, IPOs are exit options for promoters, why would a promoter sell his shares for cheap?

 

When you hire a financial advisor, you outsource the job of money management to him/her. One of the value-add that a financial advisor brings to the table is to navigate you through the markets without getting impacted by the above-mentioned biases.

Planning for your child’s education

Planning for your child’s education

Good quality education is a priority for every parent but for anyone overseas education can be a deal-breaker. Even if you have sufficient funds to meet your retirement needs, it is extremely important to separately allocate the funds for your child’s education especially graduate level studies.

Here are few mistakes that parents commit while planning for Child’s education: 

Buying ULIPs

Protect your child’s future

As parents, these wordings in an advertisement may be hard to ignore. Emotions are used by Insurance companies to lure people. These policies often have an opaque way of sharing the charges and lock-in period. Additionally, the policy maturity amount may not be sufficient to meet your child’s future needs. Therefore, securing your child’s future with these policies is not recommended. 

Underestimating the education cost

The costs today are bound to increase in the future. Often parents think of the cost in today’s value. However, the cost of education actually increases more than even the general inflation in the economy. Considering this rise in cost of education due to inflation is critical when parents plan for their child’s future.

Inappropriate investment vehicles

Allocating funds in safe assets usually give a sense of security to parents. However, the real worth of the money does not increase after considering inflation. Therefore, investment allocation towards growth assets such as equity and real estate is very important.

Insufficient life cover

Your child’s future can never be secure until you are adequately insured. You must buy a term plan that insures you for the value of your child’s future goal requirement. If something were to happen to you, your child’s future goals will still be met.

Ignoring your own retirement

Putting your own future at stake is not recommended. Children’s future planning is one of the important goals, but it should not be looked upon in isolation. Let your child’s future goal be part of your holistic planning.

Procrastinating

Parents who start late will have less time to save their money and may not be able to save enough for their child’s future goal requirement.

What you need to do

So what are the costs involved? It will depend upon where your child will go for his/her higher education. If your child chooses India over abroad education, costs could be drastically different. However, we suggest that you should plan with the assumption that you will send your child abroad for education. Later, if your child does not plan to go abroad, you can very well use those funds to meet any other financial requirement.

In today’s time, planning for $200,000 inflation adjusted for 5% p.a. is a reasonable amount of savings. You should not invest these funds in a high-risk category such as start-up funding, private equity etc.

Investments held should be viewed as a medium to long-term investment. More the time, better it is. 

Top equity mutual funds in India

Top equity mutual funds in India

Before we talk about top mutual funds in India, we must also understand the process of arriving at these mutual funds.

There are thousands of funds and selecting 3-4 funds that meet your objective is a challenge.

Most investors have “look at the past record” approach for selecting equity mutual funds. This may not be a complete answer.

For all practical reasons, you should avoid sector based funds and international funds. Sector based funds expose you to unnecessary sector risk and international funds are able to deliver only when INR depreciates. Both these situations create a unique risk and may be avoided.

Although past performance is not the only factor it is still an important factor to consider. A fund should prove its merit over a period of at least 5 years. Therefore, a fund that is recently launched may be avoided.

Now that ground rules are laid, here are the aspects to look at closely while short-listing the funds. You have to source all the funds in specific categories i.e. large-cap, mid-cap, small cap, multi-cap and tax saving funds. If you do not perform analysis basis specific category of equity mutual fund, there may be an overlap of securities that will be detrimental to your portfolio.

Criteria no. 1: 5-years Alpha

In simple terms, how well the fund has performed better than the benchmark. A large-cap category can have the benchmark as ‘Nifty 50’ whereas others can have ‘Nifty 500’ as the benchmark. Any funds whose 5-year performance is less than the benchmark may be excluded. Think about it, if the fund manager is not able to beat the benchmark, the manager is destroying value rather than adding value to the investor’s portfolio. Basis the recent SEBI’s requirement to align mutual fund schemes as per the fundamental attributes, various mutual fund houses are combining schemes that have the similar fundamental attributes. This will make calculating alpha redundant for some time since good and bad schemes combined together may indicate above average performance but that may not be a correct assessment. SEBI circular

Criteria no. 2: Information ratio (IR)

Information ratio is a measure of the risk-adjusted return. Information ratio shows the consistency of the fund manager in generating superior risk-adjusted performance. Higher the ratio better it is. IR is expected active return divided by tracking error, where the active return is the difference between the return of the security and the return of a selected benchmark index, and tracking error is the standard deviation of the active return. IR calculation may be misleading due to the recent changes to combine mutual fund schemes based on fundamental attributes.

Criteria no. 3: Asset Under Management (AUM)

As a rule, you should probably avoid funds with assets less than Rs 100 crores simply because of the relatively higher expenses associated with small funds.

Small funds may not survive or may undergo changes in the objectives in the search for greater acceptance in the marketplace. Whether through asset growth or other factors, over time a fund’s return tends to move towards the average.

Criteria no. 4: Fund manager tenure

A fund manager manages a fund. He takes a call on what to buy and what to sell and also in what proportion. Fund’s performance is directly linked to the skill of the fund manager. Therefore, the tenure of a fund manager is an important factor to consider when selecting an equity mutual fund. When managers change, a wait-and-see policy is usually appropriate.

Apply these criteria’s to filter out relevant mutual funds. You will find only a limited set of mutual funds in each of the five equity mutual fund categories.

Here is a list of funds in each category after considering the recent combination of mutual fund schemes.

Large-cap funds

  • Aditya Birla Sun Life Frontline Equity Fund
  • SBI Bluechip Fund

Large-cap funds and mid-cap fund

  • Franklin Templeton India Prima Fund
  • Mirae Asset Emerging Bluechip

Mid-cap and small-cap fund

  • Franklin Templeton India Smaller Companies
  • DSP Black Rock Small and Mid Cap

Multi-cap funds

  • Mirae Asset India Equity Fund
  • Aditya Birla Sunlife Equity Fund

Tax saving funds

  • DSP Black Rock Tax Saver
  • Axis Long Term Equity

The list of the top mutual fund is not an end but rather only a starting point. Often people get too aggressive when the markets are moving up but having a mix of assets ensures a reasonable return in all seasons. A long-term first-time investor may also evaluate Index Funds with the lowest expense ratio.

You have to structure the portfolio in such a way that your overall investment portfolio suits your behavioural aspect. You don’t want to have a heartache due to portfolio fluctuations 🙂

Why you should have a financial adviser ?

Why you should have a financial adviser ?

In India, working with a financial adviser is still not a preferred way to manage personal finances. We get informal advice from mutual fund or insurance agents on various products. We rely on these agents because we do not want to pay for financial advice. We invest in the products and later regret our financial decisions. Bad financial investment decision often leads to dis-interest in financial markets. Then, we tend to prefer keeping money in just fixed deposits. 

A pleasant experience of financial market is critical to growing your wealth. You need to acknowledge the difference between an agent and a financial adviser. There are various ways you can deal with financial services providers:

Brokerage firms

Generally these companies offer mutual funds, PMS and direct equity. The primary reason these companies exist and grow is brokerage through distribution of products. 

Wealth Management Firms

There are numerous wealth management firms that operate in India primarily focused on clients who can invest more than Rs 2 crores. These companies primarily offer mutual funds and PMS. These firms also earn through brokerage.

Banks

Banks are major distributors of financial products. In fact any financial product manufacturer would first reach out to banks for pushing the sales of new offering. Most of the banks offer mutual funds and insurance products. However, banks also earn only through brokerage.

Mutual Fund/Insurance Agents

There are thousands of these agents selling financial products especially MFs, insurance policies, LIC etc. Again these agents also earn through brokerage. 

Financial Advisory Firms

As per the guideline of SEBI, any firm or individual who claim to be financial adviser, have to register with SEBI and get investment adviser license. These firms or individuals are regulated by SEBI and have regular audits. Additionally, these firms or individuals cannot make money from commissions, hence avoid conflict of interest with the client. 

Most of the brokerage houses, banks and wealth management companies present themselves to be advisors but they aren’t. Brokerage houses, banks and wealth management companies push financial products to earn brokerage and have no interest in client’s objective. These firms do not care about quality of clients but just care about ‘quantum of clients’. On the other hand, mutual fund agents and insurance agents cannot afford to be selective because of ruthless competition and hardly any differentiation. 

Select a financial adviser after thorough understanding of their processes and approach. Make sure that you get unbiased advice from the financial adviser. This is possible only when the source of revenue for the adviser is not linked with the financial product.

Why are you saving money ?

Why are you saving money?

Everybody wants to be ‘rich’ but very few have actually sat and thought through how rich they really want to be and what they need to do, to achieve financial freedom.

Circumstances and needs are constantly changing. A sound financial situation today does not necessarily foretell an equally rosy future.

  • A loss of income, even temporary can deplete your savings or leave you in debt.
  • An uninsured loss can wipe out your accumulated wealth.
  • Insufficient savings can force you into a reduced lifestyle post retirement.
  • Frequent or unplanned borrowings can leave negative money i.e. debts for future.
  • Poor tax planning can result in higher taxes, payable separately.

All this, combined with changes in your life cycle, needs and/ or external economic changes can make you and your future generations financially vulnerable.

You need to plan and manage your current and future income to meet your current and future needs / wants. These are also known as your goals or dreams.

People who write their goals are much more likely to achieve them. Sit down by yourself or with loved ones and try to imagine your future. Consider what drives you in your life and how that has changed over the years.

While I can’t tell you what you should want in life, the list of questions below can provide you with a fair idea of how you should start thinking about the future.

  • What milestones do you foresee in the future? starting a family, sending kids to college, buying a new home etc.
  • When would you want to retire? And with how large a corpus?
  • What are some of the other things that you may want to do in life?

Once you have a timeline of your goals, you will need to estimate how much money will be needed to meet them.

A portion of your current savings will need to be invested appropriately so that it grows to meet your future goals’ cost.

Make a list of all key expenses you foresee in the future. This will give you an idea of how to invest your savings.

How to select the right Mutual Funds ?

How to select the right Mutual Funds?

There are thousands of different schemes from various mutual fund schemes and selecting the best ones can sometimes get hard.

Most folks ask friends and family or research popular online websites to get the top fund recommendations and invest in the top-rated funds.

The biggest mistake that mutual fund investors can make, is selecting mutual funds only on the basis of past performance.

Then there are some who consider the star ratings given by various research agencies. These star ratings can be one of the factors to look at, but there are other important parameters that one should also consider before finalizing a mutual fund portfolio.

The most important step in selecting mutual funds is to first have an investment goal and timeline i.e. how long do you plan to stay invested in that fund to meet your goal.

A fund selection done without an investment goal may not give the best results. You should know the reason for your investment, how long you can stay invested and at what stage you will re-allocate / redeem before you make your first investment.

Once your investment objectives are finalized, you may evaluate a fund based on the following parameters:

1.) Performance Ranking

More than the recent or long-term performance of any scheme it’s ranking among peers is very critical.

  • Firstly, you must compare the mutual fund with its peer group.
  • Secondly, you must compare the performance of the scheme with its benchmark.

The fund, which has performed well in one quarter, may not perform well in the next quarter. Funds with a good long-term top quartile performance are far superior to a fund scheme, which has one top position and one bottom position.

2.) Total expense ratio

As a fund starts to do well it starts to attract a lot of investors, and as its assets increase it should keep dropping its asset management charges.

Look at well-managed funds with charges below 1.9% p.a. – there are many.

Though mutual fund’s total expense ratio has been capped by SEBI, still lower the fees, the better it is for you unless you get some extraordinary return by paying higher expenses for a specific fund.

3.) Fund manager tenure and experience

Fund managers play a very important role in the fund’s performance. Though managing a mutual fund is a process-oriented approach, the fund manager is still the ultimate decision maker and their experience and viewpoint count for a lot. You should know who the fund manager of the scheme is and what their past track record is.

If you find that due to change in the fund manager there is a considerable effect on the fund’s performance, which does not suit your risk appetite then you may decide to exit from that fund.

4.) Scheme asset size

The lesser the assets under management (AUM) in any scheme, the riskier it’s likely to be. This is because you don’t know who the investors in the scheme are and what quantum of investments they may have in that particular scheme. An exit by any big investor from the mutual fund may impact its overall performance and the remaining investors in a scheme will have to bear the impact. In schemes with larger AUMs, this risk gets minimized.

It is recommended to invest in 3-4 funds that match and/ or complement your investment objectives. This is to avoid dependence on any one fund and avert risks of market downturns.

In addition to these, there are some additional indicators, which you can look at if you are inclined:

Alpha

This is a measure of a funds performance with respect to the index. If an alpha is 1%, it means the fund has performed 1% better than the market performance.

Beta

This indicates the level of volatility of a fund with respect to the market index. The larger the beta of a fund, the more volatile it will be.

Information ratio

The information ratio (IR) is a ratio of portfolio returns above the returns of a benchmark – usually an index – to the volatility of those returns. The information ratio identifies whether a manager has beaten the benchmark by a lot in a few months or a little every month. The higher the IR, the more consistent a manager, with consistency being an ideal trait. Conversely, the lower the IR, the less consistency.

Standard Deviation

This indicates how much the current performance of the fund is changing its past performance. A high standard deviation may not be a good indicator for the fund.

Sharpe Ratio

This ratio indicates the source of a funds performance and how much of risk the fund was exposed to, to get higher returns. The larger a fund’s Sharpe ratio, the better will be its risk-adjusted performance.

While you may shortlist mutual funds based on the above parameters, it’s a good idea to have a financial advisor on retainer who you can use as a sounding board to discuss potentially good and bad funds.