Whether its buying ice-cream at Cold Stone or filling gas at a Shell petrol station, a large proportion of companies that we consume goods and services from is backed by a private-equity firm. This makes private equity a favorable investment option for many people. In this article, we will explore how private equities work and how they can benefit private companies.
What is a private equity firm?
To put it into simple terms, private equity is a part of the much larger finance sector known as private markets. It is a type of financing, whereby, capital is invested by the investor, usually into a large business in return for equity in the company. They are termed private because the stocks in the company are not traded in a public equity market (i.e. stock exchanges).
Private equity firms are funded by pension funds, labor unions, foundations and many other powerful organizations who invest large sums of money in the hopes of receiving a large return on their big investment. Due to the hefty investments, private equities often have a large control over the industry of the companies they invest in. They invest in companies and manage and improve their operations and revenue over a period of time. Once the private equity has improved the investment value of the company, it can do one of two things. The company can issue an Initial Public Offering (IPO) to go public or it can be sold to a larger corporation at a profitable price.
Between 2000 and 2006, all private equity buyouts worth over $1 billion rose from $28 billion to $502 billion and has been at a steady upward growth since. There is no denying that is an incredibly prosperous business in the finance sector.
Here is the list of the largest private equity firms by PE capital raised:
Private equity investors have a versatile and powerful job and it is a profession that attracts the brightest and smartest people in the corporate world. The job of a private equity investor can be focused on three important tasks:
— Raise capital from large entities
Just as private companies raise money from private equity firms, private equity firms also go through rounds of funding to raise capital from large institutional investors. Sometimes, the owners of the private equity put in their own capital but this is no more than 1-5%. When raising capital, private equity firms prefer large companies that invest 10-100 million dollars each vs. many small companies that invest money in the thousands.
There are two time periods when a private equity raises funding. ‘First close’ means that the company has raised the required amount of money but new investors can still join the equity for a short period of time. The ‘Final close’ is when the private equity is done raising capital and no new investors can join.
— Buying out private companies
The main function of a private equity is to invest in private companies in both single or multiple sectors. Therefore, a large part of a private equity investor’s job is to source out potential companies, perform extensive research on why the company would be a good investment and finally implement a plan of action to acquire the company.
Prospective deals on companies usually come as a result of a partner’s reputation in the industry or from the in an auction conducted by investment banks where equity firms raise bids for a company and in each round of bidding, companies are rejected from the race. The bidding process happens for companies that have a very high potential for growth.
Once the potential companies are sourced, the private equity investor will perform the due diligence to acquire the company.
— Improve the investment value of the acquired company
Once equity in the company has been acquired, it is the duty of the private equity investors to improve operations and increase revenue in the company. The investors are not in charge of the day-to-day running of the company, rather, they take seats on the company’s board and provide advice and support on the strategies and operations management of the company.
The level of involvement by the investor can vary depending on how big their stake in the company is. If they own a large stake, they will have a significant influence on how the company is run and will be more involved in improving the workflow of the company.
The end goal of the investor is to exit the portfolio company once the investment value of the company has improved. This exit may happen 3-7 years after the company has been bought. The investors gain value in holding this investment through the revenue gained during the investment period, the reduction in costs as a result of streamlining the process and the revenue earned from selling the company which is used to pay off the debt incurred when the company was originally purchased.
Once the company’s revenue has been optimized the investors will either issue an IPO or sell it to a larger corporation.
Private Equity Strategies
Here are three commonly used private equity strategies:
— Growth capital
These are investments made in well-established companies who are looking for capital to expand their current operations or to expand their target markets. These investments are usually a minority investment by the private equity firm. The mature companies they invest in are looking to expand operations without affecting the ownership in the business.
— Leveraged buyouts
This is when a private equity firm borrows a large amount of capital to buyout other companies because they believe that they will get a significant return when they hold and eventually sell the company. Almost 90% of the LBO is financed through debt. Once the company is acquired, the private equity will either sell parts of the company or will improve the investment value of the company and exit at a profit.
— Fund of funds
A FOF strategy is when the private equity invests in various other funds and not directly into stocks and securities. Using this strategy provides a more diversified portfolio for the private equity and the ability to hedge the risk during the different stages of funding. On the downside, investing in funds of funds is expensive as there are additional fees involved such as the management fee and the performance fee.
A private equity investment is great for businesses that are looking to grow and expand their operations. The investors bring a lot of knowledge and experience to the table that can improve the company’s value and revenue and help leverage its position in both local or international markets.
In developed Asian countries like Singapore and Hong-Kong, REITs or Real Estate Investment Trust is a popular investment option. However, the concept of REITs in India is yet to gain popularity among the Indians.
In simple words, a REIT is a collective investment scheme just like a Mutual Fund. It is an investment vehicle which pools your savings and invests in the portfolio of income generating properties. REITs are licensed to operate in India by the SEBI.
Structure of REITs
Although REITs are similar to Mutual Funds, they have a three-tier structure. A REIT consists of a Sponsor, a Fund Management Company, and a Trustee.
The sponsor is responsible to set up the REIT while the Fund Management Company selects and operates the real estate portfolio of the same. The Trustee ensures that the investors’ money is managed in the interest of the latter. Trustees have defined responsibilities which involve complying with all applicable rules and regulations that protect the investors’ rights.
How does REITs work?
A REIT pools money from investors and spends that sum in diverse real estates. It creates a portfolio of real estate assets including Offices, Residential Properties, Hospitals, Restaurants, Hotels, Warehouses, Corporate Buildings, etc.
A REIT is a trust which requires to be registered with a stock exchange. It issues its units via an IPO or Initial Public Offering. These units are consequently traded as securities in the stock exchange.
You can invest in the units of the REIT scheme in a similar way that you invest in shares, either in the primary market or the secondary market. The minimum ticket size of investing in a REIT fixed by the SEBI is Rs 2 lakh.
Now, the next big question is how to make money by REITs?
You can get returns from REITs in the form of dividends. Besides, you can also earn income in the form of capital gains if the REIT makes any profit by selling any of its property.
Quick Note: The minimum assets that a REIT is required to own are fixed at Rs 500 crore by the SEBI. Further, SEBI has made a rule that the minimum issue size has to be less than Rs 250 crore.
Perks of investing in REITs in India
As per SEBI guidelines, REITs are required to pay you at least 90% of their rental incomes every 6 months. Moreover, when REITs dispose of any of their properties, they have to distribute a minimum of 90% of such capital gains to their investors.
The activities of REITs have been also made transparent by the SEBI. A REIT has to compulsorily disclose the full valuation of their investments every year. Further, they are also required to update the same on a half-yearly basis.
Further, REITs are required to invest their money in a minimum of two projects as per SEBI. If a REIT chooses to invest only in 2 projects, it has to mandatorily invest 60% of its assets in a single project.
Besides, REITs have to allocate 80% of their assets in finished and revenue generating projects. They can invest the rest 20% of their money in under construction projects, mortgage-based securities, Government securities, cash & cash equivalents, and many others.
Should you invest in REITs in India or actual properties?
Living in own house is in the bucket list of the majority of the income earning Indians. Moreover, unlike stocks or equity market, the valuations of properties don’t fluctuate drastically. Ideally, the intrinsic value of properties keeps moving upwards and hence, investing in the real estate sector seems an appropriate idea for a majority of Indians.
Furthermore, one can also earn a significant income in the form of rentals by investing in a property. And that’s why, even after owning a house property, many people prefer buying their second or third home for earning income in the form of rental (and of course, capital appreciation over time).
Nonetheless, the ticket size of investing in real estate varies from a few lakhs to over crores which might not be affordable for the major earning population of India. Here, in order to earn a regular income, investing in REITs seems more bearable because of the lower ticket size and diversification benefits.
Overall, if you are looking to invest in the Real Estate sector of India but do not have a huge corpus, REIT seems to be a more appropriate investment option for you.
REITs in India provide diversified and secured investment opportunities in the real estate sector. They are managed by professionals having years of experience and expertise who ensure to provide maximum returns to the investors at reduced risks.
By now, although investing in real estate seems profitable, but it is not free from limitations.
Firstly, no doubt, it is a profitable investment alternative for creating huge wealth but, it is only affordable for the upper-middle-class families and the affluent people. Second, both capital appreciation and rental income from properties depend on a lot of factors like infrastructure, location, industrial development, which may not always be in favor of investors.
Third, the Real estate in India has been affected by liquidity crunch in the past owing to low demand and unsold inventory. And lastly, although the Indian real estate sector is functioning under the regulations of SEBI, becoming an organized industry is still a distant future.
What is the ‘Intrinsic Value’ of a Stock? What are its components? How do they affect the way the company’s Stock is likely to behave? We will attempt to answer these seemingly daunting questions in simple terms and with relevant, real-world examples.
Intrinsic Value – What is it Anyway?
I personally rely exclusively on Discounted Cash Flow / Dividend Discounting sort of models to estimate the intrinsic value of stocks. The world’s foremost authority on Discounted Cash Flows, is in my opinion, none other than Mr. Warren Buffett, the billionaire investor and the Chairman of the half-a-trillion-dollar entity that is Berkshire Hathaway. He’s as good a teacher as he is an investor.
Sure enough, Mr. Buffett has talked about ‘Intrinsic Value’ in a number of places. In one of those interviews, he put in candidly:
“To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate. If we could see in looking at any business what its future cash flows would be for the next 100 years, and discount that back at an appropriate interest rate, that would give us a number for intrinsic value. It would be like looking at a bond that had a bunch of coupons on it that was due in a hundred years. Businesses have coupons too, the only problem is that they’re not printed on the instrument and it’s up to the investor to try to estimate what those coupons are going to be over time.”
— Warren Buffett.
Think about what he’s trying to say. In a Government Bond, you have pre-determined cash flows (Coupon Payments and Principal Repayment), a time period in which the cash flows will be credited to your bank account (Maturity) and a Risk-free Rate, which allows you to account for the Time Value of Money.
Now consider a Stock. How is it different from a Government Bond? You still have Cash Flows (Dividends and/or Free Cash Flow to Equity), but they’re not pre-determined. Businesses do not produce results in a straight line. You do have a time period, but it’s generally very long. In other words, this will be the entire Business Life Cycle of a company.
You also have a Discounting Rate, which is usually the Risk-free Rate + a Risk Premium you charge to account for the fluctuation in the results (Fluctuation which does not exist in a Government Bond). That’s it. These are the differences. So, if you are in agreement that a Bond should be valued at the Present Value of all its Coupons and Face Value, you should have no qualms in accepting that a Stock should be valued in a similar fashion too — except, it takes more time to value a Stock than it does a Government Bond.
Components of Intrinsic Value
I personally believe that the intrinsic value of a company (And consequently, its Stock) is composed of the following six components:
Without further ado, let’s take a look into each of them and why I think they matter when it comes to Value.
1. Explicit Drivers
Explicit Divers of Value are those factors which are readily considered by amateur investors while investing in a stock. In fact, most Analysts trying to sell their reports highlight the ‘Explicit Drivers’ the most, because they are easily understandable by the common man.
Management Teams also mostly flaunt their Explicit Drivers in order to boost their rapport with the shareholders. It’s made up of two sub-components: Growth and Margins.
The easiest of all the drivers. We know for a fact that as a company sells more of its products and services, the more it is known and the more revenue it produces. While thinking about how a company can grow, it has to be tied to reality.
For example, a while back I valued D-Mart, the famous Indian retail chain. In it, I had assumed that the company will grow its Revenues at the rate of 35% in the initial years, and dropping to 25% for the farther years. Here is how I attempted to ‘justify’ my assumptions.
I took the Invested Capital of D-Mart from 2009-2018 and used it to calculate Capital Required per Store, based on the CEO’s comment that D-Mart had been growing at a pace of 10 stores per year. I also calculated the Growth in the Cost of Acquisition per store for the period.
This allowed me to project the Capital Invested per store from 2019-2028. Then, working backwards with this information and my own assumptions of Invested Capital, I calculated that from 2019-2028, D-Mart will grow at an average of 19 stores per year. This coincides with the CEO’s vision of boosting D-Mart growth from 10-ish to 15-20-ish in the next decade or so. Hence, my set of assumptions for Sales Growth stood justified.
However, not all growth is good. Sustainable Growth Rate is the rate at which a company can grow its Revenue without resorting to raising additional capital, which is detrimental to Shareholders. Therefore while valuing a company, it is advisable to restrict oneself to the SGR, unless there’s a very good reason that the company’s products will suddenly become more desirable.
This refers to the Net Margins of a company. Prof. Sanjay Bakshi often quips that the best kind of value creation happens with a ‘Margin Expansion’ i.e. when a company is able to charge more from the customer for the same kind of products or services they have been selling for so long.
Warren Buffet also claims that the best measure of a Durable Competitive Advantage is to ask whether the company will be able to raise prices tomorrow without affecting sales. Of course, it is also not hard to imagine how a company can save more on its Margins by simply being cost-efficient.
Clearly, a steady or increasing Net Margins is a favorable feature in a company. As Prof. Bakshi was so apt to note, indeed Margins contribute a whole lot to Value creation. One only needs to look at some of the biggest Multi-baggers to realize this truth (Say, Symphony, Eicher Motors etc).
But this means that the opposite is also true. Take the case of Lupin, for instance. In the last five years, Lupin’s Sales has grown by 10.38%, but its Profits have decreased by 26% and change. This is because their Net Margins have fallen from 18% to 1% in the same period. In fact, Lupin has created very little value for someone who bought its stock 5 years back. It’s currently trading at almost the same level as it was half a decade back.
So while attempting to value a company, one has to ask the question “Will this company be able to charge more prices for the same kind of product/service in the future?” or “Will this company be able to spend less for producing the same kind of product/service in the future?” and depending on the answer (Based on research and groundwork), the Margin assumptions can be made.
2. Implicit Drivers
Implicit Drivers are those factors which are considered in line with the Explicit Drivers by good investors. They know for a fact that the Explicit Drivers are superficial if the Implicit Drivers are not up to the mark. Reinvestment and Risk are the two Implicit Drivers of a Stock’s Value.
Remember earlier when I said ‘All growth is not good’? While a part of it has to do with the concept of the SGR, a bigger part of it lies with the concept of ‘Reinvestment’ or the amount of Assets a company has to reinvest to a certain level of growth.
Let me provide you with two investment opportunities. Company A, which may produce Rs. 100 in Profit, but has to reinvest Rs. 50 in order to end up with that profit. Company B, which may produce Rs. 10 in Profit, but has to reinvest Rs. 3 in order to end up with that profit. If you are a smart investor, you will choose Company B, because they are more productive, that is to say, they only require 30% of their profits to be ‘reinvested’, while Company A requires 50% of their profits.
The efficiency is Reinvestment is usually measured via the Return Ratios (Return on Capital Employed, Return on Invested Capital, Return on Equity).
Charlie Munger, Warren Buffet’s investing partner, loves companies with massive Returns on Invested Capital. It is almost guaranteed that for a stock to grow multi-fold, the company has to temporarily or permanently boost their productivity.
On the other hand, look at any company in a flailing industry (Say, Telecom) and you will realize that they haven’t created any value in the last decade because they found it more and more difficult to retain customers without investing in advertising or some sort of new technology.
Bharti Airtel has grown its Sales by 10% over the last decade, yet it has destroyed value for its shareholders over the same time (Imagine having to hold a stock for 10 years, only to end up with a loss). In fact, it took a massive disruption in Jio to make the entire industry re-think how they can invest better to create value.
Risk is very personal and it’s not quite easy to explain. In fact, I wrote an entire blog post attempting to explain the fact, but I am pretty sure I didn’t even scratch the surface with understanding Risk. Without getting into complex monsters such as the Capital Asset Pricing Model or the Fama-French Five-Factor Model, the most logical definition of ‘Risk’ is an opportunity foregone.
In Finance, ‘Risk’ is usually measured as an interest rate (Termed the ‘Discounting Rate’), because the Time Value of Money demands that we do. So when it comes to investing in stocks, one needs to ask “If I do not invest in this stock, what is my next best investing option and how much am I likely to earn from investing in that option over the long term?”
I personally use a Discounting Rate of 15% for most of my valuations, because that is the median long term returns on Mutual Funds investments in India (The actual figure is 14.88% if you are curious). So my ‘next best option’ to investing in any stock is investing in a Mutual Fund scheme.
This is where it gets ‘personal’. Some people may not consider investing in a Mutual Fund as their next best option. For a Hedge Fund specializing in Start-ups, 15% may be chump change, so they may demand anywhere between 50–60% on their investments.
At the same time, for a retired pensioner, even an 8% return from a Post Office scheme would look amazing. However, even a retired pensioner can invest in an index fund and earn close to 12–13% over the long term (In India). So it’s not wise for anyone to demand anything lesser than the long term index returns in their country (For instance, in the US, it is about 8–9%). But some academics consider the Risk-free Rate (Usually the 10-year local Government Bond yield) as the true Discounting Rate for any valuation.
3. Hidden Drivers
These are Value Drivers which can be ascertained only by master investors. They aren’t found in Management Commentary, Financial Statements or Analyst Reports. They require additional research to be uncovered.
These are mostly Real Estate or some sort of Patent/Right held by the company, which has been long since written off from the books. However, if they were actually sold in the market, they might fetch a fortune for the shareholders of the company.
In the Indian context, Wonderla would be a good example. The company is currently trading at about Rs. 1550 Crores, but the company has unused land parcels of around Rs. 1000 Crores. Of course, this doesn’t mean that the company automatically demands supreme valuation. It simply means that if an investor finds the company’s intrinsic value to be Rs. 600 Crores only, he can go ahead and purchase the stock, because the intrinsic value is actually Rs. 1600 Crores, thanks to the ‘Redundant Asset’ in unused land.
But finding this bare fact isn’t really useful all the time. Take the case of Binny Mills.
Binny Limited, the listed entity which holds Binny Mills, also holds several land parcels and real estate (Mills) in Chennai. But they hold these properties in North Chennai, which is crowded and used to be a trading hub decades back (When ‘street shopping’ was famous). Nobody wants these properties, because of them being located in an archaic trading community. If it was possible to sell these off, some rich investor would have bought out Binny Mills and sold it for parts. thereby netting himself a cool profit via a Special Dividend. The fact that this hasn’t happened tells us the follies of betting on companies simply because the company has a hidden “land bank”.
Competitive Advantage Period
I saved the best for the last. This relates to the most sought-after four-letter magic word in investing: Moat. Before giving my views on this, you should check out Michael Mauboussin’s paper on this topic. It’s bloody brilliant.
It is economic truth that if a specific kind of business is profitable, competitors will emerge to get their own piece of the pie. ‘CAP’ measures how long a company can fend off the competitors, while keeping most of the pie for themselves. This is often too difficult to measure or even see, because the beauty of a good moat is realized over very long time periods. Left unattended, some competitors will breach the moat and run off with a piece of the pie. Let unattended for a long time, the moat will dry up and the survival of the company itself will become a concern.
Once again in the Indian context, I think Eveready Industries would be a great example. Post its initial success as a battery-maker, Eveready’s profits started to dwindle from 2007–2012. But the company still had an amazing ‘Moat’—the brand name, which is known to almost every Indian who’s ever used battery-run appliances. Post 2012, the new management levered the brand name into several new divisions, especially the consumer electronics space, where their products have picked up with little to no investment, thanks to the company’s brand name. The profits in the last 5 years have ballooned at an amazing pace of 56% and more. One could argue that Eveready Industries’ CAP has been lengthened dramatically, which led to the sudden spike in their stock price.
I usually use a 10–20 year projection period, based on a company having no moat, having a thin moat or having a massive moat. The truth stands that very good moats can make companies have CAPs in excess of 20 years (Think Coca-Cola).
However, the Time Value of Money will make sure that profits earned 100 years from now aren’t as important as the ones earned, say, 15 years from now. I still adjust for this by demanding a lesser Margin of Safety for companies that have a proven operating model and a Moat.
In the end, this is just the theory behind why I do what I do when I Value a company. To put it lightly, Value is a marriage of numbers and stories. One cannot do without the other. Only when these ‘stories’ are grounded in reality using ‘numbers’, does the Valuation get complete?
I’m the quintessential geek and a strong INTP-A. Saying ‘I am passionate about investing’ would be an understatement. I have been investing my own and my family’s money in the Indian markets since 2016. I’m also a voracious reader and listener of topics ranging from cattle rearing to particle physics. When I am not busy investing or reading, I blog about Valuations and Markets at Valuation in Motion. I believe that finance is as simple as knowing where your last dime went. And I hope to show you how.
Economics is the study of how humans use limited resources (land, labor, capital and enterprise) to manufacture goods and services and satisfy their unlimited needs and distribute it among themselves. It is divided into two broad branches, microeconomics and macroeconomics.
Each branch has its own policies and regulations relating to different sectors such as agriculture, labor market and the government. Microeconomics is the study of the behavior of an individual, firm or household in the market while macroeconomics is the study of the economy as a whole- that is, the individuals, households and firms collectively.
What is Microeconomics?
Microeconomics was first introduced by the economist Adam Smith and is the study of the economy at a lower level, it is commonly termed the ‘bottom-up’ approach. This branch of economics focuses on how decisions made by people and organizations can affect the economy as a whole. As individuals, we make numerous decisions everyday from what clothes to wear to what food to eat. These decisions are made by the different agents in the economy and serve as the basis for microeconomists to study how they affect supply and demand and ultimately the economy as a whole.
Tools such as supply, demand, consumer behavior, spending and purchasing power of people are used by economists to build models that they base their learnings on, one such model is the supply and demand curve. By understanding the buying and spending habits of people, economists come up with various theories to understand relationships between different elements and how these small parts fit into the larger picture.
However, in the real world, things are different and cannot always be represented through a model. Hence some economists study subsets of microeconomics such as human behavior which is the actions taken by an individual when making a decision and the behavioral model which uses disciplines such as psychology and sociology to understand how people make decisions.
Since microeconomics is the study of the economy at a lower level, many people use it as a starting point for learning economics. The theories used in microeconomics are then used to study the economy at a larger scale- also known as macroeconomics.
While microeconomics is a bottom-up approach, macroeconomics is considered a top-down approach as it is the study of the economy on a larger scale. Prior to 1929, many economists only studied microeconomics (people’s individual decisions) however after the crash of 1929 (aka the great depression), many economists were unable to explain its cause. They found that there were forces in the economy, which based on people’s decisions, could have a positive and negative impact. In addition to looking at individual decisions, it was also important to look at the big picture.
Macroeconomics is the study of larger issues affecting the economy such as economic growth, unemployment, trade, inflation, recessions and how decisions made by the government can affect the economy. For example, the Central Bank creates their interest rate policies based on the macroeconomic conditions in the country and around the world.
John Maynard Keynes is considered the founding father of Macroeconomics and his understanding of the subject was largely influenced by the Great Depression. During the 1930s Keynes wrote an essay titled The General Theory of Employment, Interest and Money where he outlined the broad principles of Macroeconomics that led to the development of Keynesian economics. Keynesian economics are macroeconomic theories about how during a recession, in the short run, the output is influenced by the aggregate demand in the economy. Milton Freidman another pioneer of macroeconomics used monetary policy to explain the reasons for the depression.
Micro vs Macro Economics -The key differences
As mentioned earlier, microeconomics is the study of individual and household decisions and the issues they face. This could be analyzing the demand for a certain good or service and how this affects the production levels of a company. It could also be the study of effects of certain regulations on a business.
While macroeconomics is the study of the economy as a whole. This involves looking at the gross domestic product (GDP) of the economy, the unemployment rates and the effects of inflation, deflation and monetary policy. For example, they may look at how an increase in taxes can affect the economy using the GDP, national income and inflation rate as a metric rather than individual factors.
Microeconomics is useful for determining the prices of goods and services in the economy along with the costs of the factors of production (land, labor, capital) while macroeconomics helps maintain price stability and creates policy to resolve problems dealing with unemployment, inflation and deflation.
However, both micro and macroeconomics come with their limitations. For example, the study of microeconomics assumes that there is full employment in the economy. This can lead to unrealistic theories as this is never true. In macroeconomics, there is a fallacy of composition where economists assume that what is true for an individual is true for the economy as a whole. However, in the real world, the aggregate factors may not be true for individuals too.
Micro and macroeconomics are interlinked
By definition, microeconomics and macroeconomics cover completely different aspects of the economy and while this is true, the two fields are similar and also interdependent on each other.
When dealing with inflation, many people think of it as a macroeconomic theory as it deals with interest rate and monetary policy. However, inflation is an important part of microeconomics because as inflation raises the prices of goods and services, it reduces the purchasing power that affects many individuals and businesses in the economy. Like inflation, government reforms such as minimum wage and tax rates have large implications in microeconomics.
Another similarity in microeconomics is the distribution of the limited resources. Microeconomics studies how the resources are distributed among individuals while macroeconomics studies how they are distributed among groups that consist of individuals.
Although micro and macroeconomics affect different levels of the economy and cover different policies, they are in fact two sides of the same coin and often overlap each other. The most important distinction is their approach to the economy. Microeconomics is ‘bottom-up’ and macroeconomics is ‘top-down.’
Have you ever heard of DVR shares? In the year 2008, Tata Motors came out with the DVR shares for the first time in India. These DVR shares of Tata Motors trade at a discount of 50% compared to their normal shares. Later, this DVR issue approach of Tata Motors was followed by multiple companies like Jain Irrigation, Future Enterprises, Pantaloons India, etc.
What are DVR Shares?
First of all, many people have a misconception that DVR shares are similar to preferred shares. However, in reality, both these shares are different. Preferred shares usually do not carry voting rights.
On the other hand, DVR shares are similar to normal Equity shares. One notable difference in DVR and normal share is that the DVR equity shares have differential voting rights. A DVR share may have higher or lesser voting rights compared to an ordinary share. Another major difference is that the holders of DVR shares receive a higher dividend than ordinary shareholders.
Although both DVR shares and ordinary shares are traded in a similar way in the stock market, however, DVR shares are traded at a discount as they have generally offer lesser voting rights.
Why companies issue DVR shares?
Issuing DVR shares help the company in raising equity capital without adversely affecting its management and control. In other words, DVR shares result in bringing passive investors in the company’s list of members and can also protect the company from a hostile takeover in some scenarios. Moreover, as these company generally issues DVR shares at a considerably discounted price, this makes such shares attractive to prospective investors. Therefore, it enhances the likelihood of the company to raise a huge equity share capital.
Are DVR Shares good for retailers?
As stated earlier, DVR shares have generally fewer voting rights. However, if you are a retail investor with a small number of shares in a company, this type of share may be suitable as you are more concerned with dividends than voting rights.
Further, as these shares trade at a discounted price compared to the normal share, they may be more attractive for retail investors over normal shares. You can definitely consider investing in DVR shares of a company if you are looking to generate long-term wealth rather than seeking control in the issuer entity.
The concept of DVR shares looks like an attractive alternative for investors so far. After all, retail investors are more interested in getting dividends than attending Annual general meetings (AGMs). However, the concept of DVR shares is yet not flourishing in the Indian securities market because of a few common reasons.
For example, TATA Motors offer DVR shares, but only with 5% dividend advantage. Therefore, hypothetically, if dividend per ordinary share is Rs 10, the dividend on a DVR share is Rs 10.5. This makes the investors analyze whether it is worth waiving around 90% of voting rights for receiving a dividend hike of just 5%. (A Tata Motor DVR has 10 percent voting right as compared to an ordinary Tata Motor share).
Further, the majority of Institutional investors are more interested in checking a company rather than enjoying higher dividends. Therefore, financial Institutions show less interest in the DVR shares as they seek participation in managing the affairs of the company.
Overall, although the DVR shares seem to be advantageous for both the issuer company and the shareholders, one simply can’t ignore their shortcomings. Nonetheless, if these cons can be worked upon, the DVR shares can eventually become one of the best financial instruments in the Indian financial market.
A prominent question many people have about investing in stocks is, “Does the purchase price matter?” or “Should I value a stock before purchasing it”?
A lot of financial theory argues that you shouldn’t. They say, markets are always efficient in pricing securities and you should rather worry about decreasing frictional costs like brokerage charges, transaction charges, churn costs and so on.
But Mr. Charlie Munger, the business partner of the world’s richest investor Mr. Warren Buffett, has a different answer:
“It was always clear to me that the stock market couldn’t be perfectly efficient, because, as a teenager, I’d been to the racetrack in Omaha where they had the pari-mutuel system. And it was quite obvious to me that if the ‘house take’, the croupier’s take, was seventeen percent, some people consistently lost a lot less than seventeen percent of all their bets, and other people consistently lost more than seventeen percent of all their bets.
So the pari-mutuel system in Omaha had no perfect efficiency. And so I didn’t accept the argument that the stock market was always perfectly efficient in creating rational prices. The stock market is the same way – except that the house handle is so much lower.
If you take transaction costs – the spread between the bid and the ask plus the commissions – and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that, with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.
It is not a bit easy…But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking. To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.”
Let’s say that you are about to bet $100 on a Horse Race. A total of ten horses are participating in the race and you are given the following statistics:
You are told that 100 people have laid down their bets (Let’s call them the ‘Horse Market’) and the total pool of bets is $4,050. Indirectly, you can assess how these 100 people have determined the probability of winning, or ‘Odds’ of winning, for each of these horses. In fact, Horse #6 seems to be an overwhelming favorite, with $1,700 bet for the horse.
But before blindly betting on Horse #6, you need to understand the most important thing about Parimutuel Betting. If Horse #6 indeed wins, everyone who bet on Horse #6 will get $4,050 i.e. Everyone will make roughly 2 times of their bet amount (For convenience, let’s just say the remaining 0.38 times is participation fee). Is that good?
Hold your horses (Pun intended)!
If you bet on Horse #5 or Horse #9 instead, you can make 81 times the money, instead of the paltry 2 times. Well, well, now is this a better bet? Logically speaking, these horses have had a very little bet on them because they may be poor to begin with. The 100 gamblers already know this. That’s why only 1-2 of them have placed bets for these horses.
Wait, this is confusing. Which horse should I bet on now? Let’s recount the statement made by Mr. Charlie Munger:
“We look for a horse with one chance in two of winning and which pays you three to one. You’re looking for a mispriced gamble.”
A mispriced gamble. That’s where the trick lies. To summarize Mr. Munger’s thought process:
You shouldn’t bet blindly on Horse #6, because you will only make only 2 times the money, the lowest reward of the lot. Even when Horse #6 can be deemed the healthiest horse with the most skilled jockey, the payout is simply too low.
You shouldn’t bet blindly on Horses #5 or #9, even though they have an astronomical payout of 81 times. It is more likely that Horses #5 or #9 could be sick/weak or their jockeys inexperienced.
The sweet spot, therefore, is in a bet where you think there’s mispricing i.e. A bet where the ‘Odds’ have been miscalculated by the Horse Market people. Take Horse #1 for instance. The Odds here are 8:1 i.e. The Horse Market people think there’s only a 12.50% (1/8) Probability of this horse winning. If you believe that these Odds are somehow way wrong i.e. If you believe that this horse actually has a 25% (1/4) Probability of winning, then you should consider betting on this one. Of course, you should repeat this exercise for all the horses and figure out which one has the most mispriced Odds and bet on that one.
Sounds simple enough? Horse Betting is decidedly more complex than this. However, it proves to be an interesting lesson in investing. This system of Parimutuel Betting, Mr. Munger argues, also applies to the Stock Market. I would personally visualize it like this:
To put it in a words, then:
You shouldn’t invest blindly in the well-known, excellent company. Although these type of companies have the lowest probability of making a Capital Loss (i.e. Chance of not achieving the Average Returns) over the long term, they also have a low, 15% returns over the long term. Put together, they have an Expected Returns of 12%, which is neither too high, nor too low.
You shouldn’t invest blindly in the unknown, terrible company. Although these type of companies can become potential ‘multi-baggers’ over the long term, clocking a CAGR of 23%, they also come with a high 50% risk of a potential Capital Loss. Put together, they have an Expected Returns of 11.50%, the lowest of the lot.
The sweet spot, therefore, could be in the lesser-known, mediocre companies. These type of companies offer a decent 18% CAGR over the long term and also come with a moderate, 30% Capital Loss probability. Put together, they have an Expected Returns of 12.60%, the highest of the lot.
Of course, this is just an example. There are thousands of Stocks listed around the world and there might very well be numerous permutations and combinations of this in action at any given time. Instead of the 100 people from our horse betting example, the Stock Market consists of millions of people. They are pricing the odds for a stock every moment a trade is executed. It is an investor’s job to figure out the most mispriced bet and pick it up.
Just remember. You don’t make the most money-per-risk-taken by betting on the most favorite gamble. And you don’t make the most money-per-risk-taken by betting on the least favorite gamble, either. You make the most money-per-risk-taken by betting on the gamble where the odds are highly mispriced.
That’s it for today! I’ve used the word ‘Intrinsic Value’ several times in this post, without really letting on much what it is supposed to be. Think about what it means. Let’s explore this more in ‘Equity Valuation 102’, the next post.
I’m the quintessential geek and a strong INTP-A. Saying ‘I am passionate about investing’ would be an understatement. I have been investing my own and my family’s money in the Indian markets since 2016. I’m also a voracious reader and listener of topics ranging from cattle rearing to particle physics. When I am not busy investing or reading, I blog about Valuations and Markets at Valuation in Motion. I believe that finance is as simple as knowing where your last dime went. And I hope to show you how.
It is no secret that the finance sector is a fast-paced, competitive environment where it’s survival of the fittest. When you factor in gender dominance into the equation, there are often more hurdles that women need to overcome to find long-term success in the industry.
According to the World Economic Forum Gender Gap report in 2017, ‘female talent remains one of the most underutilized business resources’ and this is especially true in the finance sector where although 46 percent of the industry are women, they only represent 15 percent of executive level positions.
While this statistic is shocking, it’s true. There are many women in Finance who believe that the right personality traits, qualities and skills, regardless of gender, can get you to the top of your career. Here are a few career tips from the top successful women in Finance:
Network, Network, Network
As they say, ‘it’s about who you know, not what you know.’ Getting to the top of your game in the financial industry involves having a broad network of connections. According to Sally Krawcheck, CEO and Co-Founder of Ellevest, it is the number one rule for success in business- for both men and women.
Building a strong network requires time and patience and a lot of hard work on your part. Your professional network can include people from all walks of life, who share the same passions as you and can help you achieve all your career goals. But networking is a two-way street so while you reach out to others for help, you should develop a mutually beneficial relationship and aim to be their ‘go-to’ person at a time of need. You’ll find that your kindness will be repaid in multifold.
Find your passion and work towards it
Do what you love and you love and you’ll never have to work a day in your life. Before you take up a job, be it in finance or any other industry, you need to make sure you are passionate about what you are doing. This is exactly what Edie Hunt, the Chief Diversity Officer at Goldman Sachs, did. She always looked for opportunities that highlighted her passions and aligned with her personal and professional goals. Hunt believes that if you are passionate about your job, there’s a high chance that you will be good at it.
However, Wei Sun Christianson of Morgan Stanley says you should not fill your goals with only passions as you may hit a rough patch during your career and can get disheartened. When chasing your dreams it is important to be driven and develop a versatile skill set to get that job!
Never stop learning
The opportunity to learn new things every day is a driving factor for many in their career. Elle Kaplan, the CEO of LexION capital says that her ‘deep-seated intellectual curiosity’ is a motivating factor to learn new things every day. For her, the financial markets are always changing and they are constantly impacted by a variety of elements from politics, to current events and even climate change. Keeping up with the constant changes in the markets gives her the opportunity to soak up a wealth of knowledge every day.
The gender gap presents an opportunity
It comes as no surprise that the finance sector is a ‘boys club’ and women often find it a challenge break into the industry. Francesca Frederico of Twelve Point Wealth Management says that with the right outlook on life, you can turn a challenge into an opportunity. Instead of trying to fit into a male dominated environment, use your expertise and skills to do things your way. Women need to think outside the box, be more willing to take risks and follow their dreams. Not only is it an enlightening feeling to be yourself, but you will see that not doing things a certain way is not always the right way.
Take the risk
The greater the risk, the greater the reward. In order to find success in the finance world, women need to trust their gut and take the risks to get the most out of their career. Although you may face many trials and tribulations to the top, you need to follow your instincts and take the leap of faith to reap big rewards. At the end of the day, your journey of risk-taking should lead you to a job that you are passionate about.
Bonus: It’s not always about the money, focus on making a change
This does not just apply to jobs in the financial industry but to any job you have in your life. While paying your bills is important, you need to use your knowledge to make a difference in the lives of the people around you. Many financial leaders use their skills to educate people on wealth management and investing. This is a system that is a necessity for many people in world as nearly a majority of the population has a hard time saving money.
Although there is a gender gap, there are still many women blazing a trail in the finance industry, they took the risks and fought for what they believed in, ultimately making their mark. The future is bright for women in finance and it is up to us to find our passions and work diligently towards them. So this Women’s Day encourage the women around you and climb higher mountains and celebrate each other’s successes.
“Every great dream begins with a dreamer. Always remember, you have within you the strength, the patience, and the passion to reach for the stars to change the world.” —Harriet Tubman
A large proportion of the Indian population considers Gold as one of the best options to invest in India. Here, gold is not only treated as a satisfactory long term wealth creator but also auspicious and a symbol of social status. As per the World Gold Council, India ranks second in the globe in Gold consumption, after China. Up to 20-25% of the world’s Gold is consumed in India in the form of jewellery, bars, coins etc.
Ironically, a few years back, the fixed deposit was considered more promising investment options for the middle-class Indians. However, nowadays, the interest earned on FDs has gone substantially down, because of which FDs don’t seem to be as genuine potential wealth generating option like earlier. These days, people are again revealing a lot more inclination towards Gold investment.
Anyways, Gold is a long term investment option and not suitable for earning short term gains. Moreover, the prices of Gold fluctuate in a cyclical manner. Therefore, one cannot expect Gold to perform well all the time.
Why should you invest in Gold?
Indians have been investing in gold for thousands of years and it has so far proved to be a solid investment option. Here are a few best reasons why you should invest in gold:
— Gold acts as a hedge against inflation: History states that Gold has performed relatively better compared to equities or other investment options in the scenarios of high inflation. Stock prices do not have any functional relationship with inflation. However, as Gold belongs to the commodity market when the economy witnesses rising inflation, the Gold price goes up.
— Investing in gold won’t cost you a fortune: Unlike investing in real estate (which requires a bigger investment amount) or equities (which require paperwork to open your trading account), investing in gold is easier for most of the average Indians and does not require a big amount to get started.
— Investment in gold offers high liquidity: If you own a Gold coin or jewellery, you can easily liquidate it as you can sell your physical gold at a local jewellery shop anytime. Although stocks and mutual funds can also be converted into cash fast. However, such instruments do take a few days time to process the redemption and the selling amount to get credited in your bank. As compared to these securities, Gold offer higher liquidity.
— Gold investment can help you to balance the risk in your portfolio: In order to reduce the portfolio risk, it is important to diversify your investments. Gold, having a negative correlation with Equities, can help you in diversifying your portfolio in a convenient way. Whenever your equity portfolio is going through a bear phase, a notional loss on the same can be absorbed by your gold investments.
First of all, Gold investments do not only mean investing in physical Gold like gold coin or jewellery. There are various other ways available for investing in Gold in India.
Although investing in Gold via jewellery is decent in terms of generating long term wealth. However, keep in mind that when you purchase Gold jewellery, you have to pay the making charges too. Despite, when you sell that jewellery, you will only get the price for the Gold (and not the making charges that you paid earlier). Instead of investing in Gold jewellery, opting for Gold coins or bars seems a better choice. The latter is more profitable because here you do not need to pay the making charges.
Anyways, you can also invest in gold via Gold Mutual Funds. These funds invest in those companies which carry out extraction and mining of Gold or marketing of the same. The Gold Fund schemes are managed by skilled and experienced Fund Managers and are highly liquid. Therefore, investing in these Funds is a convenient option if you are looking to invest in gold. Nonetheless, the cons associated with the gold fund is that you might have to pay an exit load on your investments. Apart from that, you also have to pay an expense ratio which is deducted from your NAV every year for management and operational expenses.
Further, Gold ETF is another option while investing in gold. It works in a similar manner like Gold Mutual Funds but the same is traded on a stock exchange. However, you need to have your own Trading and Demat Account with a broker to invest in a Gold ETF. In addition, Gold ETF does not allow you to invest via SIP mode, unlike Gold Mutual Funds.
Lastly, if you want to invest in gold via the direct stock market, you can opt for investing in Gold mining companies. Investing in Gold mining stocks means investing in companies engaged in the mining and marketing of Gold. The performance of these stocks is not only related to the fundamental factors of the companies but is also dependent on the Gold rates.
Cons of investing in Gold
No investment option is perfect and gold investing also have some limitations. Here are a few key pointers which you should keep in mind while you invest in Gold:
— Gold does not generate sufficient returns like stocks or bonds: Gold is not a passive investment option. Investing in gold does not offer dividends or interests. Therefore, the only way to make a profit from Gold investment is by selling off.
–– Your Gold investment may demand safety against theft or robbery: Gold is a valuable asset. If you are planning to keep physical Gold, storing the same might be a matter of concern. Alternatively, you may store your physical gold in a bank ‘locker’ but this may cost you periodical maintenance charges.
— Investing in Gold is not tax-free: When you purchase physical Gold, you will be charged GST on the same. Moreover, Gold is treated as a capital asset. Therefore, whenever you sell Gold for profit, a tax on short term capital gain or long term capital gain is applicable. You can read this blog to know more about taxation of Gold in India.
— Gold investing is cyclical: As we discussed earlier, the prices of Equities and Gold usually move in the opposite direction. When the stock market witnesses a bearish (downward) trend, the Gold price goes up and investors find Gold an attractive investment option during these times. However, when the cycle changes and the stock market goes in a bull run, the gold price starts going downwards and gold investing may be ignored by the investors.
In this post, we covered the basics of investing in Gold. If you are seeking a regular source of income through your investments, Gold may never serve this purpose. However, if you want to hedge your existing investments in Equities and Bonds, you should consider investing in Gold. Further, if you are planning to invest in Gold for the very first time, it is recommended to start investing via Gold Mutual Funds or Gold ETF.
Apart from acting as a hedge against inflation, Gold comes in handy during the situation of financial crisis. Nevertheless, you should not treat Gold as your only choice, but consider it as one of the investment options in your portfolio. Ideally, you should allocate up to a maximum of 10% of your portfolio in Gold.
Whether you invest in Gold or not is solely your choice. However, what matters more is the clarity in your mind regarding why you are investing in the same.
Understanding what is SEBI and role of SEBI in Financial Market: The capital market started emerging as a new sensation in India at the end of the 1970s. However, with the popularity of stocks, a number of malpractices also started rising like price rigging, unofficial private placements, non-compliance with the provisions of the Companies Act, insider trading, violation of stock exchange rules and regulations, delay in making delivery of shares and many others.
As this time, the Indian Government realized the need for establishing an authority to reduce these malpractices and regulate the working of the Indian securities market as the majority of Indian People started losing their trust in the stock market.
Initially, SEBI acted as a watchdog and lacked the authority of controlling and regulating the affairs of the Indian capital market. Nonetheless, in the year 1992, it got the statutory status and became an autonomous body to control the activities of the entire stock market of the country. The statutory status of the SEBI authorized it to conduct the following activities:-
SEBI got the power of regulating and approving the by-laws of stock exchanges.
It could inspect the accounting books of the recognized stock exchanges in the country. It could also call for periodical returns from such stock exchanges.
SEBI became empowered to inspect the books and records of financial Intermediaries.
It could constrain companies for getting listed on any stock exchange.
It could also handle the registration of stockbrokers.
SEBI is headquartered in Mumbai and having its regional offices in New Delhi, Chennai, Kolkata, and Ahmedabad. You can also find SEBI’s local offices in Jaipur, Guwahati, Bangalore, Patna, Bhubaneswar, Chandigarh, and Kochi.
At present, 17 stock exchanges are currently operating in India, including NSE and BSE. The operations of all these stock exchanges are regulated by the guidelines of SEBI.
The organizational structure of SEBI
Mr. Ajay Tyagi is the current chairman of SEBI. He was appointed on the 10th of January, 2017 and took over the charge with effect from 1st March 2017 from Mr. U.K. Sinha.
SEBI consists of one chairman and other board members. The honorable chairman is nominated by the Central Government. Out of the eight board members, two members are nominated by the Union Finance Ministry and one member is nominated by the RBI. The rest five members of the board are nominated by the Union Government.
The objectives of SEBI
SEBI’s responsibility is to ensure that the securities market in India functions in an orderly manner. It is made to protect the interests of investors and traders in the Indian stock market by providing a healthy environment in securities and to promote the development of, and to regulate the equity market.
Further, as stated earlier, one of the prime reason for establishing SEBI was to prevent malpractices in the Indian capital market.
SEBI’s main roles in the Indian financial market
In order to achieve its objectives, SEBI takes care of the three most important financial market participants.
— Issuer of securities. These are the companies listed in the stock exchange which raise funds through the issue of shares. SEBI ensures that the issue of IPOs and FPOs can take place in a transparent and healthy way.
— Players in the capital market i.e. the traders and investor. The capital markets are functioning only because the traders exist. SEBI is responsible for ensuring that the investors don’t become victims of any stock market manipulation or fraud.
— Financial Intermediaries. They act as mediators in the securities market and ensure that the stock market transactions take place in a smooth and secure manner. SEBI monitors the activities of the stock market intermediaries like brokers and sub-brokers.
The functions of SEBI
The SEBI carries out the following three key functions to perform its roles.
1. Protective Functions: SEBI performs these functions for protecting the interests of the investors and financial institutions. Protective functions include checking price rigging, prevention of insider trading, promoting fair practices, creating awareness among investors and prohibition of fraudulent and unfair trade practices.
2. Regulatory Functions: Through regulatory functions, SEBI monitors the functioning of the financial market intermediaries. It designs the guidelines and code of conduct for financial intermediaries and regulates mergers, amalgamations, and takeovers takeover of companies.
SEBI also conducts inquiries and audit of stock exchanges. It acts as a registrar for the brokers, sub-brokers, merchant bankers and many others. SEBI has the power to levy fees on the capital market participants. Apart from controlling the intermediaries, SEBI also regulates the credit rating agencies.
3. Development Functions: Among the list of SEBI’s development functions, one of them is imparting training to intermediaries. SEBI promotes fair trading and malpractices reduction. It also educates and makes investors aware of the stock market by utilizing the funds available in IEPF.
The stock market is one of the most crucial indicators of a country’s economic health. If people lose faith in the market, the number of participants will go down. Furthermore, the country will also start losing FDIs and FIIs considerably which will substantially hamper the country’s foreign exchange inflows.
Before SEBI was established many scams and malpractices took place in the Indian stock market. One of the famous Indian stock market scams was “Harshad Mehta scam.”
After SEBI came into power, stock market affairs started becoming healthier and more transparent. Nonetheless, some securities mark scams have taken place even after SEBI came into power. One famous such scam was “Ketan Parekh scam”
Although unfair activities do happen in the Indian capital market even as of today, their frequency is quite less. Moreover, the security market statutes and regulations are updated time and again. Therefore, day by day, SEBI is getting more and more stringent with its authority.
Growing up, we’re often told to save for a rainy day. As kids, many of us didn’t heed this advice, choosing instead, to spend our money on the next best toy or video game. However, it is only when we grow older that we realize the importance of the values our parents instilled in us.
Learning how to save money from a young age is known to have numerous benefits. For one, it teaches you the value of money and motivates you to work towards your goal of buying a new book or a video game you really want. While kids put their money into a piggy bank for a rainy day, adults use the same principle to save their money in a bank account known as an Emergency Fund.
What is an Emergency Fund?
As the name suggests, an emergency fund is money that you put aside for emergencies. It is the money that you can reach out to during your hour of need and pay for those unforeseen and unexpected expenses such loss of a primary job (the main source of income), medical emergency, personal emergencies or even a car breakdown. You need to have a solid financial plan for the future and an emergency fund is an essential tool in helping you do just that.
Many people often find it hard to grasp the concept of saving for an unexpected circumstance as it is much easier to live in the movement and spend money on the things you love- money buys happiness, right? But an emergency fund can help you in darkest hour and statistics provide the proof. According to a report by the Federal Reserve on Economic Wellbeing in the U.S. Households in 2015 showed that when faced with an emergency of $400, 47% of Americans had a hard time coming up with the money without using their credit card or borrowing from family and friends. This shocking statistic is reason enough to start working on that emergency fund immediately.
The financial experts recommend that before you start making investments for your long-term goals, first you should build an emergency fund which should be greater than at least three times your monthly expenses. In other words, even if you lose your primary source of income, you should be able to survive at least three months through your emergency fund. For example, if your monthly expense is equal to $2,500, then you should have at least $7,500 in your emergency fund. It would be even better if you can build an emergency fund to cover six months of your expenses as it will reduce the need to draw from high-interest debt options, such as credit cards.
Moreover, this fund should be highly liquid i.e. readily accessible in case of emergency situation. A few good options to build your emergency fund is via savings account or money market funds. Additionally, avoid investing your emergency fund in instruments with lock-in periods or those which are subjected to penalties in case of early withdrawal.
How to build an emergency fund?
By now you understand why an emergency fund is so important and want to create one for yourself. Building an emergency fund is incredibly easy and only requires some discipline and resilience on your part.
So how do we do this? Like with all other things in life we need to start small. Here are a few ways to help you get started:
1. Big things have small beginnings
Saving is key to having a financially secure future and have an emergency fund is an important part of this. Saving a large amount of money for an expense that may or may not happen in the future is a hard thing to do. So take baby steps with your fund and start with saving small amounts of money. This could even be as low as $30-$50 dollars a month as long as you are actively putting away money for the future. Although you start out small, you need to have a goal as to how much money you would ultimately want to have in your emergency fund. Setting a fixed goal makes it easier to work towards it.
2. You don’t need all that coffee
Many people live paycheck to paycheck and often find it hard to put away money for the future. If you find yourself in such a situation, you need to look at your existing expenses and try to cut back on what is unnecessary. You can start by accounting for your expenses every day and putting them into different buckets. This can help you identify areas that you spend too much money on like all that expensive coffee or those frequent restaurant meals. If you are really trying to build that rainy day fun, try cooking all your meals at home for at least 5 days a week.
3. Automate it!
To successfully build an emergency fund you need to control your expenses and put away a certain amount of your paycheck every month. While this is easier said than done, one way to make the process simpler is by having an automatic transfer of a fixed amount from your bank account every month. This serves two purposes, one, the amount in your bank account will be lower meaning that your expenses will be in control and two, you won’t even have to think twice about putting away money since the process is now automated!
4. Get creative with saving
As you begin to get more serious about building your emergency fund, you can find new and creative ways to save money. When you begin to assess your income and spending, you may find some unnecessary leaks in your income. This could be canceling subscriptions that you no longer use for magazines or apps. These payments are automatically charged to your debit or credit card and can add up quickly. Additionally, with over the top (OTT) platforms like Netflix and Amazon Prime, the trend has shifted to online entertainment, making cable TV obsolete. So take a good look at your cable channel list and try to cut channels that you no longer watch or need. While these costs may not seem as much, they can amount to a lot of savings over time.
Alternatively, look for ways to increase your income stream. You can get a freelance job or have a side hustle like babysitting or dog-walking.
While the goal of an emergency fund is to save money for a rainy day, it is also important to reward yourself once in a while. This doesn’t have to be a big splurge, it could even be a meal at your favorite restaurant or a new book. Rewarding yourself will motivate you to keep going and achieve all your saving goals!
An emergency fund can help you when you have a financial setback and is an essential tool for financial success. In addition to saving money, you will have the added advantage of earning a high-interest rate on the money. Once you’ve built up a system of saving money every month, you are well on your way to building that emergency fund but most importantly make sure to use your money wisely!
The Dow Jones Industrial Average (DJIA) or the Dow is an index of 30 companies that many investors are confident about investing in. It shows the market valuation of companies such as General Electric, Exxon Mobil and Microsoft Corporation and is a good reflection of how the markets are performing. A common strategy used by traders when investing in the Dow is the ‘Dogs of the Dow’ strategy.
This strategy involves a trader buying the top 10 stocks with the highest yield from a bucket of 30 stocks in the Dow. The idea behind this strategy is that blue-chip stocks with a high dividend yield is a sign that these companies are currently facing a downturn in their business cycle and in the upcoming year these values are sure to increase as the company goes through its cycle.
What is the DJIA?
The DJIA or the Dow is one of the most famous and trusted indices in the world. Founded by Charles Dow during the 19th century, the DJIA assesses the value of a basket of 30 blue chip companies based in the United States. Blue-chip stocks are shares of large, well-recognized companies that have a high valuation and a long history of trading on the stock market.
Here are the 30 stocks that make up the Dow Jones Industrial Average as of today.
Usually, when people say ‘the market is doing well’, they are most likely referring to the DJIA. The index also provides valuations for certain industries such as the Dow Jones Utility Average and the Dow Jones Transportation Average. Other famous indices like the DJIA include the S&P500 index which is an index that values 500 companies.
The DJIA calculates the value of 30 blue chip companies whose valuations have a large influence on the economy and are a good reflection of the current market conditions. The companies that are to be included in the DJIA are selected by editors of The Wall Street Journal.
When valuing the companies, the Dow only considers the average price of the stock and not the company’s market capitalization. Hence if both company A and B have a stock price of $40 but their market capitalizations are $30 million and $90 million respectively, as per the index calculation both companies will have the same impact on the market and the movement of the DJIA.
But the DJIA index differentiates between stock splits, spin-offs etc using a divisor. Before the divisor, the total value of the stock prices was divided by the total number of stocks. However, if there was a stock split in one of the shares, dividing it by the total number of shares will not provide an accurate value of the DJIA.
With the divisor, the value of the stock will be calculated as follows:
Say a stock has a share price of $50 that is split into two and the total sum of all the 30 stocks in the bucket is $1096. The first step will be to subtract the split stock from the total: 1096-25= $1,071.
To find the new divisor after the stock split you need the new sum by the index value before the split. Therefore: [1071/(1096/30)]= $29.32 (new divisor)
The new DJIA= 1071/29.32= $36.53
Why is the Dogs of the Dow strategy great for investors?
Using the calculation shown above the DJIA provides the valuation of 30 large companies that have a high market valuation and provide an accurate reflection of the market conditions. The Dogs of Dow strategy, introduced by Michael B. O’Higgins in his book Beating the Dow, picks the top 10 companies out of the 30 included in the index based on their dividend yield. The Dogs of the Dow are a list of the current 10 companies ranked by their yield in the prior year from highest to lowest. The dividend yield is the ratio of the total dividends paid out to shareholders to the market value of its shares. Therefore companies with a high dividend yield pay out a large amount of their revenue in the form of dividends.
The Dogs of Dow is an optimal strategy for many investors as it ensures that they receive a high return on their investments. Many investors usually pick stocks based on the number of dividends they receive and buying the stocks with the highest dividend yield (10 Dogs of the Dow) will ensure that the investor earns a good return.
Furthermore, as the dividend yield of a company increases, it signifies that a company is facing a downturn in their business cycle and as all cycles have their ups and downs, buying a Dogs of the Dow stock with a high dividend yield is a sign that the company will have an upward movement in the upcoming year. Stocks that are currently going through a slump tend to have a low share price that is attractive to many investors.
What companies are the Dogs of the Dow in 2019?
Historically, the Dogs of the Dow stocks have shown positive returns for investors. In 2015 and 2016 they had price gains that beat out the Dow but faced a low point in 2017 as they only had returns of 19% in comparison to the Dow’s 25%. In 2018 however, the current Dogs of the Dow faced losses of 4% that were still significantly lower than the losses faced by the Dow at 6%. While this strategy does not always promise returns, it is appealing to many investors as the high yielding stocks usually have a lower price and is a safer option to buying all 30 stocks in the Dow.
Here are the top 3 Dogs for 2019:
— Exxon Mobil: The price of oil per barrel has increased steadily during 2018 from $60 per barrel to $70 per barrel but ended the year at only $45 a barrel. This is a sign that Exxon Mobil may have an upward turn in its stock prices in 2019. Two factors that can lead to better market conditions for Exxon are the ongoing talks between the US and China along with a cut in oil production by OPEC nations. The second factor is Exxon’s aggressive growth plan that hopes to double their returns in the upstream and downstream business.
— Pfizer: Pfizer’s popular pharmaceutical drug Lyrica had a dip in sales in 2018 and lost a lot of market share in the U.S and Europe. However, with a change in management this year, Pfizer is more optimistic about 2019. Moreover, the company has more than 30 drugs in the pipeline that it hopes to receive approval for by 2022.
— Cisco Systems Although there has been an increase in Cisco’s dividend in the last few years, many investors are choosing to invest in younger tech companies, leaving older companies like Cisco behind. However, Cisco plans to rectify this issue in 2019 as they are turning all their subsidiary services into subscription models which they hope will help them leverage their position in global markets and increase revenue. They also have a 3% yield which is a high value in comparison to other DJIA companies.
The Dogs of the Dow strategy is great for investors to diversify their portfolio and receive above-average returns. While the current Dogs of the Dow stocks may not seem to be doing well in the market currently, they are sure to increase in value by the end of the year.