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Index: Stock Market Key Terms

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STOCK MARKET KEY TERMS

Index term index usually refers to a basket of some finite assets


(stocks/bonds/commodities etc) which as a group forms the
best representation of the space in which many similar assets
lie.
Market Index Nifty and Sensex are the market indices of National Stock
Exchange (NSE) and Bombay Stock Exchange (BSE) respectively.
A market index serves as a benchmark that allows us to
understand general price movement of stocks on the exchange. 
First, we will need to create a basket of sample stocks-
Including most frequently traded stocks from different
sectors of the market like banking, pharma, IT, metals etc.
will give best results.
Once the basket is created, we can observe the price
movement of the stocks within, to conclude the general
price trend of the market.
Nifty is a sample of 50 listed and frequently traded stocks on
NSE, selected from across different sectors.
Sensex is a sample of 30 stocks from across different sectors
all listed on BSE.
Create an index There are many IT companies listed on the exchange, so the
natural question is which companies should be selected to
be included in the basket?
Shares Outstanding = Total number of shares issued by the
company
Market Cap = Current Price * Shares Outstanding
(This tells me what is the current value of a company)
Market cap of company X will be Rs 1,000. It means that the
total value of the company (cumulative value of all shares) is
Rs 1,000.
Each listed company in IT sector will have its own market
cap/value.
If we add all these market caps, we will get the total market
cap of IT sector i.e. combined value of all the listed
companies in the IT sector.
Let’s revert to the question of selecting stocks for our
Index.
10 companies, out of 1000, are very big and represent
almost 90 percent of the total market cap of the sector.
Since 10 companies represent most of the market cap of the
sector, we could just select these 10 to form a representative
basket of the IT industry.
Let’s assume Infosys is one of the stocks that I hold and I
have Rs.100 worth of the company’s shares.
So the company has a weightage of 10% (100/1000) of
my investment amount.  
Stock weightage=value of investment in the stock/total
value of all investment.
As I invested equally in all the 10 stocks, weightage of each
of the stock in my portfolio is 10%.
When we create an index or buy a basket, number of shares
of each stock remains constant, however weightage of each
stock does not.
Weightage represents the portion of total value represented
by a single stock and as the stock price changes everyday,
weights do too. 
Calculating Index While calculating an index value, we want to see how
Value investment value has been moving on a daily basis
compared to the base value.
While calculating an index value, we want to see how
investment value has been moving on a daily basis
compared to the base value.

Whenever creating an index, fix the initial value to a base


number and then track progress of the investment by
comparing it to the base value.
Sensex has a base value of 100, fixed in 1978-79 and now it
has increased to more than 25000.
Nifty has a base value of 1000, fixed on 3rd Nov’95 and has
crossed more than 7500. 
It is prudent to create an index for your investments. Index
creation allows one to easily understand returns and follow
& track investments. Smallcase platform makes available
easily trackable custom indices for your portfolio/investment.
It’s time you upgrade the way you invest.
Types of Indices Price Weighted :  stocks in the index are weighted based on
their prices,  stock with the highest price will have the
highest weight
Market Cap Weighted : stocks in the index are weighted
based on their market capitalization, stock with highest
market cap has the highest weight
Equal Weighted : stocks in the index are equally weighted
In our example, price weighted methodology generated maximum
return. However the outcome would have been completely
different had the stock price fluctuated in some other manner.
At smallcase, you can easily pick the desired weighting scheme or
use the one recommended by our platform. Picking the right
weighting scheme is very important, as it can significantly impact
your returns.
EXAMPLES
 first step is to select companies from all segments of
the sector to make the best possible representative
sample. Nifty Media includes broadcasters, printers &
publishers, film production houses and other
segments of the Media sector.
 Once companies are selected, weights are decided
based on the market cap weighting methodology.
 The company with highest market cap will have the
highest weight. At the beginning of Jun’15, index value
of Nifty Media was 2108. The same value at the end of
Jul’15 was 2452.
 Using this we can quickly say that Media sector
generated a return of 16.3% (2452/2108-1), in these
two months.
 Similarly, we can calculate the returns generated by
other sectors and compare them with each other to
know which sector is performing the best.
Tracking these tailor-made, easy to use indices enables an
individual to quickly ascertain a sector’s health, its historical
performance compared to other sectors, and helps him make
a better investment decision. Let’s now learn and understand
about custom indices.
Benchmarking Point of reference matters – Einstein
A custom index refers to an index tailored as per one’s
specific needs and expectations.
To understand the meaning and applicability of custom
indices, first we need to understand what we mean by
benchmark/benchmarking.
Two ways of measuring performance: absolute and relative.
Absolute measurement-piece of information does not allow
you to understand whether you won the race.
Hence it is not a useful way of measuring performance.
If you are told that your timing was just 2 seconds slower
than the race record, this can also be interpreted as good
performance. These are examples of relative measurement.
In the first case, your performance was measured relative to
that of other participants and in second case measurement
was relative to previous record.

In finance and investment world, performances are generally


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

Let’s consider another example.


I now want to invest in a few IT companies and over a period
of time compare their performance with that of IT sector in
general.
Our post on “Sector Indices”, informed us that Nifty IT sector
index is a good way of tracking the performance of Indian IT
sector.
Hence I define Nifty IT sector as my benchmark and
invest in a basket of IT stocks that I feel will perform well
going forward.  
After few days, I see that my investment has generated a
return of 10%, however my benchmark Nifty IT index has
returned 15% during the same period confirming that my IT
basket has underperformed the sector index.
In other words the stocks that I bought performed poorly
when compared to the IT sector in general.
It is prudent to always define a benchmark to measure the
performance of your investments.
If you are investments are in a specific sector then a sector
index might be a good benchmark.
However if your investments are sector agnostic, then
broader indices like Nifty and Sensex might be good
benchmarks.
Custom Indices The smallcase way of investing
There are many ready-made/standard indices available on
stock exchanges, they might not always fulfil investor’s need.

Hence investors might want to build their own custom


indices.

Suppose you believe that it is the right time to invest in


pharmaceutical companies and want to buy select
companies in the sector.
The smallcase platform makes available a
basket/smallcase/index called Pharmacase that allows you to
take position in representative group of companies from the
pharma sector.
Pharmacase consists of 5 stocks  (AA,BB,CC,DD,EE) and has
an equal weighting scheme.
We know that in an equal weighting scheme, all stocks in the
portfolio have equal weights; hence each stock in
Pharmacase has a weight of 20%.
However being a prudent investor you have done your
research and believe that stocks BB and DD will perform
better than other stocks in Pharmacase and you want to
assign higher weights to these stocks.
Your preference is to allocate 35% weight each to BB & DD
and distribute the remaining 30% weight amongst the
remaining 3 stocks.
So you now customize the index by assigning higher weights
to stocks BB & DD and also decide to use Pharmacase as
your benchmark.
Assuming a total investment of Rs.100 and price of each
stock to be Rs.10,
Draw table illustrates how the value of your portfolio will
change, relative to the value of Pharmacase, if only
prices of stocks BB and DD rise by Rs.1 after one day.

Understanding Financial Statements


Financial Statements (i) Why assets are always equal to liabilities??
Used to gauge the health of a company
Give us a quick snapshot of how much profit the company
has been making over the years;
How much of that profit has been returned to investors in
the form of dividends;
What are the liabilities &
Whether the assets are sufficient to fulfill these liabilities?

Let’s assume you want to set up an auto parts


manufacturing plant and need some money for the
same. You have three options to raise funds:

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


local bank

Option 2: Take money offered by your dad’s friend and


bring him on board as an investor/shareholder

Option 3: A mix of the above two options

Your total initial requirement is Rs 1,00,000.

You have decided to take a loan of Rs 50,000 from the


bank and

borrow the remaining Rs 50,000 from your dad’s


friend.

You intend to use the funds for the following


purposes:

Rs 40,000 for machines,

Rs 40,000 for building & other infrastructure and

Rs 20,000 for raw materials.

Two basic items in a balance sheet: assets and


liabilities.
Assets All the tools, machines, infrastructure, building and
other things acquired by you for manufacturing auto
parts are called assets
everything bought and owned by you using the
money you raised, is classified as an asset.
Assets are created when funds are utilised to buy
articles that are going to help generate cash in the
future.
Assets can be further broken down into fixed, tangible
& immovable assets and movable current assets.
Plant and machinery will be classified as fixed,
tangible and immovable assets because they are
relatively immovable and have a very long life.
Raw materials will be classified under movable
current assets, as they have a very short life span and
will be required to replenish at regular intervals.

Assets are sourced by using funds, liabilities are the


source of funds. 
Answer to- assets are always equal to liabilities. 
Amount you borrowed from bank needs to be repaid
over the next few years and will be classified as long
term liability.
Money you raised from your dad’s friend is not a loan
but an investment in your company. It is classified as
shareholder’s equity and your dad’s friend will be a
shareholder of the company.
Financial Statements (ii) Understanding capital structure of a firm
Let’s say you decide to name your firm ABC Inc. 
Total assets of ABC Inc. is worth Rs 1,00,000 and total
liability is also equal to Rs 1,00,000. 
Assets into current assets and fixed & immovable
assets.
Liabilities were classified as shareholder’s equity and
long-term bank liability.
Few commonly used terms: debt, equity and leverage.
Debt is a liability Amount of loans raised by the company on which it is
has to pay interest every financial year. i.e. amount of
Rs.50,000 taken as loan from the bank.
Equity Initial investment put in by different
investors/shareholders- Rs 50,000 investment put in by
your dad’s friend. 
A company can raise more funds through equity route
by issuing new shares.
In such a scenario equity will increase by a
proportionate amount.
Leverage  Ratio of debt to debt plus equity
(debt/(debt+equity)
In ABC’s case leverage is 50% (=50000/100000).
Hence ABC is 50% levered.
debt/equity ratio of 1:1 or 50%:50% in this case, is also
known as the capital structure of the firm.

Financial Statements (iii) A company's salary slip- Income Statement.

Balance sheet Gives us an idea about the assets and liabilities of a


company, as of a specific date.
Income statement Give details about what has happened over a specific
period of time.
A company can utilize profit after tax in 3 different ways:

 Entire amount can be distributed to shareholders.

o In ABC Inc.’s case this would be your dad’s friend and


you who are the owners/shareholders of the company.

 Some part is distributed as dividend and some part is


invested back into the company,
o For research and expansion purpose
 Entire profit amount is invested back into the
company

Early stage companies- retain most of the earnings as they


have enormous potential to grow and capture market
share.
Mature companies who have already grown a lot tend to
distribute most of the income to shareholders in the form
of dividends, due to lack of growth opportunities.
For example, one cannot declare what is the revenue as of
a particular date, because revenue is generated over a
period of time.
It is important to specify over what period this revenue is
generated.
On the other hand, one can always specify the amount of
assets as of a particular date.    

Key Financial Ratios


It is also hard to deduce inferences about the company
just by looking at raw numbers.
Hence in order to quickly analyze all the raw data derived
from income statement and balance sheet and to make
our investment decision we use financial ratios.
Some of the important ratios are explained below.
Return on Equity Income generated per unit of equity invested.
(ROE) How much returns shareholders/investors are getting on
the money invested by them in the company
Not all returns will be credited to the investor’s account.
ROE = PAT (income statement) / Total shareholder’s equity
(balance sheet)
It is usually expressed as a percentage
One argument against investing in ABC Inc. is that past
performance doesn’t guarantee any future performance
and that the company might not generate high returns next
year.
One should always look at the ROE history of a company to
understand how much returns can be expected in the
future.
Also helps in comparing two different companies.
However please make sure that  only apples are
compared to apples, i.e. similar companies from same
sectors should be compared to each other.

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

DPS is total dividend declared by the company/total


number of shares
n case of ABC Inc, DPS = 2000/500 = 4. Hence dividend
yield of ABC Inc = 4/100 = 4%.
When you buy shares of any company, there are two
different types of returns that you can expect, 
Capital gains
Dividend income

Suppose, you buy one share of ABC Inc today at a price of


Rs 100 and sell it back after one year at a price of Rs 125.
In this case, you will generate a capital return/price return
of 25% (125/100-1).

Suppose ABC Inc. declares a Rs.4 dividend during this


period your total returns will be Rs.29 (price return +
dividend return). 
It’s very important to understand that when you invest in
shares, your total return is not just the price return, but
price plus dividend return.
Dividend yield is an indication how much dividend can be
expected on the investment.
In ABC Inc.’s case an investor can expect to get Rs 4 as
dividend on an investment of Rs 100.
Dividend is just one part of the return
Stock prices of growth companies grow fast in response to
company’s higher growth rate, thereby generating
substantial capital gains. 
One should always consider dividend yield when investing
in a company’s stock, as it can be significant part of the
return that might be generated.
High dividend yield stocks are a good investment avenue to
supplement your income needs.
Net Profit Margin Ratio of net income generated in a year to total sales /
NPM revenue.
NPM = PAT / Sales
In case of ABC Inc, NPM is 12% (12000/100000=0.12). 
Means that for every Rs 100 worth of auto parts sold by
ABC Inc, a net income of Rs 12 was generated. 
Items like cost of goods sold, interest, taxes and others
are subtracted from total sales / revenue, to finally arrive at
net income.
NPM ratio tells us how efficiently a company is
converting its sales to profit.
Better management of taxes, raw materials, inventory and
operational efficiency can lead to substantial profits.
Thus in case of two different companies of same size
which operate in the same sector
Company which has higher NPM is more efficient, as it
can generate more profits by selling the same amount of
goods.
Dividend Payout Ratio tells us how much of profit is distributed to
Ratio shareholders/investors in the form of dividends.
It is calculated by dividing total declared dividends by
PAT/net income.
Payout Ratio = Total dividends / PAT
In case of ABC Inc, the ratio would be 16.67%
(2000/12000=0.1667). 
Tells us that only 16.67% of the profit generated by ABC
was distributed to investors and rest was invested back in
the company. 
So early stage companies might have small payout ratios
compared to large companies.
Key Investment Ratios
Other ratios which combine financial statement items
with market prices and help us make better investment
decisions.
Price-Earnings price paid per unit of earnings
Ratio (PE)S Let’s assume 1 kg of wheat costs Rs.X at the nearby
supermarket.
Now suppose, 1 kg of wheat represents one unit of a
company’s earnings.
Price of Rs.X represents the market price of 1 share.
So, when you pay Rs.X to buy 1 share of a company,
basically you are buying 1 unit of company’s earning by
paying Rs.X.
Calculated by dividing current market price by earnings per
share.
PE ratio would be X as X/1 = X.
You might have read that PE ratio of a stock is 25 or Nifty is
trading at a PE ratio of 16.
You might naturally wonder why anybody would pay that
much to buy Rs.1 earnings. 
Understand that when you pay money and invest in a
company, you are eligible to receive a part of the earnings
generated by the company, every year, as long as you hold
the share.
Let’s suppose there are two companies operating in the
same sector and are expected to perform similarly in the
future.
A has a PE ratio of 18
B has a PE ratio of 20.
We can easily say that A is undervalued compared to B as
it has lower PE ratio.
It would be prudent to buy shares of A as we have to
pay lesser amount per unit of earnings compared to
shares of B.
PE ratio of companies operating in different sectors cannot
be meaningfully compared.
Only PE ratio of companies operating in the same sector
can be meaningfully compared to each other.
One can also compare the current PE ratio of the
company with its historical PE to deduce whether the
stocks is currently undervalued/overvalued.
Price-to-Book First understand book value of a stock.
Ratio (PB Ratio) Book value-amount that a shareholder can recover from a
company if the company decides to shut its business today.
Let’s assume XYZ Inc. received INR 500 crore through asset
sale
Has liability of INR 300 crore in the form of bank loans.
Now company will have INR 200 crore left which can be
distributed to owners/shareholders.
In this case book value of XYZ Inc is INR 200 crore.
If the company has 20 crore shares outstanding, each
shareholder will then receive INR 10
(200/20) which is the book value per share.
Now suppose XYZ is a publicly listed company and the
current stock price is INR 15.
Price to book value ratio is defined as the current price
divided by book value per share. (15/10)=1.5

Means that you need to pay more to buy a stock, than what
will accrue to you if the company decides to shut down its
business today.
Investors will buy at this price only if they believe that in
future, value of net assets will grow as company progresses.

If the value is below 1, then it usually means that


investors do not believe that the company will be able to
recover the book value.

PB ratio-Price to book value ratio of less than 1 could


indicate that the stock is undervalued and it is a good
investment opportunity. 

Ratio could also be less than 1 because investors believe


that the company will not do very well in the future and
might not be able to recover the amount represented by
the book value. Hence it is prudent not to base
investment decision on just PB ratio.
Just like in the case of PE ratio, PB ratio of 2 different
companies can be compared only if they operate in the
same sector.
A company’s current PB ratio can also be compared with its
historical ratio.
Correlation Correlation represents how any two variables move
together.
Discuss how correlation is used and interpreted in stock
market
Value of correlation always lie between -1 and + 1 (-100%
to 100%)
Correlation number indicates nothing more or nothing
less. 
We say that correlation between Stock A and Stock B is
80%---means??
Means that out of 100 times when stock price of A
increases, stock price of B will increase 80 times. 

Reverse can also be true that out of 100 times when stock
price of A decreases, stock price of B will decrease 80 times.
Correlation tells us what’s the probability of increase in
stock price of B, when stock price of A has increased or
what’s the probability of decrease in stock price of B, when
stock price of A has decreased. 

Correlation doesn’t tell anything about the extent of


expected movement in a stock, based on movement in
another stock.
Beta Beta is a measure of risk
Let’s understand two types of risk faced by a company.
Unsystematic risk (Specific risk)- labor strike, as only the
stock price of Maruti was impacted, not the other stocks.
In this case, if I had put all my money in Maruti’s stock,
definitely I would have been hospitalized. But if Maruti was
a small part of my portfolio, then I might have suffered a
small loss.
Mitigation strategies :-Why we say that company specific
risk can be avoided by investing in various unrelated
stocks, i.e. having a diversified portfolio.
Market Risk- This is not a company specific risk, but the
general market risk. political party called CNG headed by a
very weak politician
Irrespective of the fact that whether I have invested my
money just in Maruti or have a big portfolio of unrelated
stock, I would have experienced a significant loss.

That is why we say it’s not possible to avoid market risk by


investing in a portfolio of unrelated stocks, as all will be
impacted by market events.
If the beta of a stock is more than 1-
means stock moves along with market in the same
direction and is more volatile than the market.

So if market is expected to increase by 10%, a stock with a


beta of more than 1 is expected to generate more returns
than 10%. 

In a bull market we invest in high beta stocks, to


enhance returns.

If beta is less than 1-


means that stock is less volatile and not related to the
market.
These stocks are best bet in a bear market, to protect
against sharp price drops.
Volatility
Risk & Return - Sides of High returns can’t be achieved without taking appropriate
the same coin
risks.
Any rational person will be willing to take more risk, only if
it comes with a promise of better returns.

Let’s assume there are 10 horses participating in a race


and we need to place our bet on one of them.

Multiplication factor represents the factor applied to


your investment, if you win the bet.

So if you put INR 30 on Horse 3 and it wins the race, you


would receive INR 240 – your money will grow 8 times the
initial investment.

Horse with highest number of wins in the past will have


the lowest factor, because it’s most likely that it will win
the race again (low risk, low return).

Horse with lowest number of wins will have the highest


factor, as probability of it winning the race is low (high
return, high risk).

It doesn’t mean that you should take risky bets. It means


that if you take risky bets and win, you would be rewarded
more.

Horse 7 has the lowest multiplication factor, as it has


historically been most consistent in winning races.

We can say that its performance is less volatile.

Horse 8 has very high multiplication factor, as its


performance has been very inconsistent in the past.
We can say that the performance of Horse 8 is very
volatile.
But the return that can be expected from this stock would
also be low. Generally, more volatile the returns
(performance) of a security are, more risky it is.

Trend, Support & Resistance


Trend Your best friend
Technical Analysis says that if the stock price is moving up
and making higher highs and higher lows, it is in uptrend.

If we join all the highs, it’s called resistance. If we join all


the lows, it’s called support.

Trend- General pattern or direction followed by price of a


stock in a specified time period.
A stock price never moves in a straight line. 
Follows a random pattern with successive highs and lows.
If the price seems to be heading upwards, it’s called an
uptrend.
If the price seems to be heading downwards, it’s called
downtrend.

When we are not able to recognize any pattern, as


happened in the middle portion of the chart –
A trend is classified as a long term trend, if it lasts for
more than a year.
Short term trends are the ones which last for around 1-
2 months.
Could be multiple short-term trends in a long term trend.

A stock might be in a long term uptrend which has been


observed over the last 5 years, but currently experiencing
short term downtrend due to factors which are not
expected to last long.

Support and when we plot support and resistance by joining lows and
Resistance:
highs of a stock price and determine a trend.
we expect the stock price to move between these two
lines.

If stock price moves below the support line, it means


that the trend has been broken and there is excess
downward pressure on the stock.

When stock price moves above resistance, again trend


has been broken and there is excess upward pressure on
the stock. 

Uptrend- speed of increase in no of people interested in


buying stock has increased

Price and volume as the two important indicators tracked


and studied by technical analysts.

Volume A buy is a sell

Note- number of transactions are always measured for a


particular period, say 1 hour or 15 minutes and not at any
particular moment.

Number of transactions is not the sum of buy and sell


activities, but the total number of buy or sell activities
which is equal to the total number of sell or buy activities.
This is because one cannot buy unless someone else is
willing to sell.

Here-transactions is volume-in stock


Volume of a stock---total number of transactions taking
place in a stock during a particular time period.

If one were to say that volume of a stock at 10.45 AM is


50,000, it means that since the open of the market at 9.20
AM a particular stock has been bought and sold 50,000
times.

Price & Volume is an important indicator to understand


whether money is moving into or away from a
particular stock.

Sudden increase in volume of a stock could be because


of two reasons.

Increased demand for the stock might have pushed up


activity in the counter leading to price increase.

Alternatively, current shareholders might be selling the


stock in droves, increasing activity in the counter thereby
lowering prices.
Volume also indicates liquidity available for a stock.

Liquidity refers to the ease with which a stock can be


bought or sold in the market without affecting its
price.

Whenever an investor wants to buy/sell stocks in huge


lots,

it is prudent to check the average volume over the past


1 month / 3 months to make sure that price impact is
limited.

Volume is increasing in a bull trend, it means that


momentum is increasing and more and more people
are joining the trend.

Volumes are decreasing in a bull trend we can assume the


the stock is losing momentum and the trend might
reverse soon.

Investing Strategies
Growth Stocks of quality companies
Recording above industry average growth and are
expected to continue doing so in the future.
Because of the company’s future growth prospect,
market often assigns high value to such stocks resulting
in a high PE ratio
Primarily concerned with fast growing young
companies
Investors who buy growth stocks focus on earning
investment returns almost exclusively through capital
appreciation resulting from increasing stock price.

Growth companies usually retain cash for reinvestment


purpose and do not pay dividends.

Growth at a Fair Price-smallcase


Market often assigns high valuation to growth stocks
everything has a fair price and irrespective of the quality
of the product/stock, one should never overpay

collection of companies-
experiencing earnings growth,
witnessing margin improvement
increasing return on capital, and
are still available at justifiable valuations
Coffee Can Portfolio selects companies whose revenue has grown by at least
10% every year for each of the last 10 years and ROCE
was at least 15% for each of the last 10 years.
strategy helps you rise above the market volatility and
noise by going for a long-time horizon of 10 years.
it also helps in saving transaction cost, as there is no
re-balancing done once bought
Value Stocks of companies which trade at a lower price
relative to its fundamentals are termed value stocks.
Mature companies with stable cash flows but
moderate growth rates usually trade at low levels. 
Sometime, Negative perception about the industry or
company due to multitude of reasons might also result
in stock price of the company taking a beating resulting
in cheap valuation

Value investors seek out stocks with strong


fundamentals –
high operating and net income margin,
positive operating cash flow,
low debt to equity ratio,
high return on equity etc – that are trading at a bargain.

Investor hopes to gain via capital appreciation when


the market identifies the true potential of the stock and
price increases

Bargain Buys
Designed for a layman investor and consists of stocks
which boast of strong financial position, manageable
debt and stable earnings.

Based on Benjamin Graham’s investment philosophy. 


Also Warren Buffett’s mentor, Graham is widely known as
the father of value investing

His belief – that inexperienced equity investors should


invest into conservatively financed companies with long
history of profitable operations

Value and Momentum

stocks which are undervalued compared to ther


industry peers.

Have been attracting attention off late as evidenced by


their recent stock price movements

Stocks have also earned higher than expected profits


during the latest reported period.
Sustainable Earnings

Companies which have been recording higher sales and


earnings, increasing their cash flows but are trading at
lower levels compared to their peers.

Dividend Dividend is a portion of company’s net profit that is


paid out to shareholders.

Dividends are usually issued as cash payments

Financially secure mature companies usually tend to


payout dividends on a regular basis providing
investors with a stable source of income.

A simple dividend investing strategy involves investing in


companies that have a consistent history of paying
out dividends.
You can buy the Dividend Aristocrats small case to
execute this strategy

This small case consists of companies which have


increased their dividend payout consecutively, for the
last 10 years.

A high dividend yield / increasing dividend yield can be


due to either higher dividend payout or falling price,
with the former scenario preferable.
A company whose dividend yield is consistently above
industry average is a good investment bet

The smallcase consists of companies who have


maintained an average dividend yield of at least 3% over
the previous 10 year period without any slash in dividend
during that period.
What is a Portfolio?
A portfolio is a collection of financial instruments
Your portfolio is a selection of financial instruments in
which you have invested your money. 
we mean various investment options like
Shares, Mutual Funds, Real Estate, Banks Fixed Deposits
and Bonds.
If you put-
INR 20,000 in stocks
INR 15,000 in mutual funds
INR 10,000 in Bank FD.
Your total initial portfolio value was INR 45,000,
When it increase current total portfolio networth of you
is INR 62,000
Weight of stocks in your portfolio increased from 45% to
49%
Weight of any instrument is current value of the
instrument divided by the portfolio net worth
Shows the portion of total networth represented by a
particular instrument
Instead of investing in different types of financial
instruments, one can invest in different financial
instruments of the same type.

For example, you can buy 3 different stocks. 


Reliance, Maruti and SBI

the total portfolio networth changed from INR 95,000 to


INR 1,05,000.
Calculating a Portfolio's If you put-
Return
INR 50,000 in Reliance
INR 20,000 in Maruti 
INR 25,000 in SBI.
Your total initial portfolio value was INR 95,000 
When it increase (5 years) current total portfolio
networth of you is INR 1,05,000
Total cumulative value = investment increased by INR
10,000 (=1,05,000 – 95,000), in last 5 years
Networth Sum of values of all the investments.
Amount that you will receive, if he wants to liquidate his
investments (sell whatever he owns).
Total money that he can generate by selling all his
investments is INR 1,05,000 which is equal to the
portfolio net worth.

If you decide to liquidate all investments--- will receive


additional INR 10,000 on his investment of INR 95,000

Thus, the current return generated by his portfolio is


10.53% (=10,000/95,000) 
Portfolio Return = (Current Networth – Initial Net
worth) / Initial Networth
Using the same logic, we can say that Reliance, Maruti
and SBI generated a return of -30% (-15,000/50,000),
50%(10,000/20,000) and 60%(15,000/25,000),
respectively.
weight of an weight of an instrument as the portion of total
instrument portfolio value represented by the instrument. 
Reliance’s weight in the portfolio dropped from 53% to
33%--means
Value of portfolio represented by Reliance dropped by
20%
Can happen only if the value represented by SBI and
Maruti increases by 20%
Maruti now represents 29% (8% more than the initial
composition) and
SBI represents 38% ( 12% more than the initial
composition).
Thus, SBI experienced the highest growth, followed by
Maruti and then Reliance. 
Thus, growth in value of the investment in Reliance
would be definitely less than SBI and Maruti.
Diversification If you speak to any experienced equity investor, the first
advice would be to always maintain a well-diversified
portfolio.
Risks associated with equity investing and the meaning
of diversification.
Two types of risks associated with this investment.
Risk involved Company specific risk- risk of something wrong
happening specifically with the company you have
invested in.
Labour strike, resignation of a CEO etc

Broader market risk- is not specific to any company in


particular and affects the stock prices of all companies.
Government not being able to pass important reforms in
parliament, a natural calamity
Risk mitigation Diversification comes from investing in unrelated stocks
and is the key to risk minimization. 

If your portfolio has 10 banking stocks and your friend


has 10 stocks from 10 different sectors, obviously your
losses will be very high, compared to your friend, if any
bad news regarding banks hit the market.

But the market risk is non-diversifiable. Even if you


invest in 10 different stocks from various sectors all will
be negatively impacted with a news like higher taxes,
instable government or large-scale natural calamity.
Thus, we cannot diversify away the market risk.
As we keep on increasing the number of stocks in the
portfolio, company/sector specific risk keeps on
decreasing.

As shown in the graph below, it is generally believed


with 30 stocks you can completely diversify away the
specific risk and only risk remaining in your portfolio
would be market risk.

Weighting a 1. Equi-Weighted
2. Market-cap Weighted
Portfolio 3. Custom Weighted

Equi-Weighted
Market-Cap Weighted
Thus, market cap portfolio will be more exposed and sensitive to movement’s in
SBI stock price, compared to equal-weight. This is happening because majority
of your money is still concentrated in one particular stock and company
specific risk is very high in the absence of proper diversification.

Custom scheme

There is no set patter to derive this amount.


Here the decision could be based on some exclusive information or investor’s gut
feeling.

For example, you might believe that PNB is expected to perform better than
other stocks, then you can give a higher weight to PNB, compared to others.

Once weighting scheme is decided, rest of the steps are similar to market-cap
and equal-weight schemes.
By this formula, portfolio of banking stocks generate a return of 11.84%
(5927.92/50056.15). 

By this formula, portfolio of banking stocks generates a return of 11.84%


(5927.92/50056.15). 
Benchmarking & Tracking
Once we have created our portfolio, the next step is to define a benchmark for
the same. A good benchmark should have similar risk and return characteristics
to our portfolio.

For banking sector example- Bank Nifty would be a good Benchmark

Bank NIFTY is an index on National Stock Exchange of India comprising of the big
banks in India.

The index will also benefit from the recapitalization decision of government,
which formed the basis of us creating this PSU banks portfolio. 

The index faces the same set of risks faced by all banking stocks--because the
risks like rising interest rates and low loan demand are same for stocks in our
portfolio, as well as stocks in Bank NIFTY.

Now, suppose in a period of 3 months, our portfolio generates a return of 10%.


Generally, we would be very happy to know this.

But if we get to know that Bank NIFTY generated a return of 15%, in the same
time period, then what?

In this case, our portfolio underperformed the benchmark by 5%.

Means that our stock selection was not good, as the general sector (represented
by Bank NIFTY) outperformed our portfolio.

If our portfolio generates a return of 18%, then we can confidently say that our
stock selection was superior, as through our selection of banking stocks based on
some criteria, we outperformed the broader banking sector.

Thus, it is very important to use right benchmark in order to determine whether


we are able to outperform the broader market through our stock selection.

If our portfolio had IT stocks, then CNX NIFTY IT would be a better Benchmark.

Auto sector companies, CNX Auto

If our portfolio comprises of stocks from different sectors, then we can use Nifty
as a benchmark. This would tell us whether we are able to beat the market
through our portfolio selection or not. 
Similar to our portfolio, we can create a custom index for benchmark
also.
Index creation process is exactly same for the benchmark and the portfolio.

Assuming NIFTY as benchmark, below table summarizes the index values at


different dates.

If we observe that on Day 9 the value of our portfolio is 57300.12 and the value
of the NIFTY is 7590.24, its very difficult to conclude anything.

But instead, if we are told that the index value of the portfolio is 114.79 and
index value for NIFTY is 104.75, we can quickly conclude following things
without any calculations:

 Portfolio has generated a return of 14.79%


 NIFTY has generated a return of 4.75% in the same period
 Portfolio has outperformed NIFTY by around 10%
By looking at the first graph, we can’t say anything. But with the second
graph, we can comfortably conclude how our portfolio has been performing,
compared to Nifty. We can easily find out how our portfolio was performing to
Nifty, on historical dates also.

Rebalancing a Portfolio
we invested Rs.50,000 in a portfolio of banking stocks. The total amount was
allocated amongst the 5 stocks in equal proportion.
Suppose we revisit the portfolio after a year, the market value of each security
within the portfolio will most likely be different, thereby affecting the weightage
of the security within the portfolio.

In the case of our imaginary portfolio both PNB and BOI saw exaggerated price
movements which resulted in drastic change in their weightage within the
portfolio.

One option that we have in this case is to ignore the change in weightage and
continue to hold the same number of shares.

This strategy will allow an investor to earn good returns only if BOI continues to
perform well and PNB continues to perform poorly.

Suppose the investor decides to retain the portfolio weights hoping that BOI
and PNB will continue to perform in line with their historical performance.

In case of the below example, share price of both BOI and PNB increased
during the year.
While share price increase is always good news, in this case the

portfolio was less affected by the 40% increase in price of PNB and

more affected by the only 5% increase in share price of BOI.

This was because of the respective weights of the scrip’s within the portfolio.

Hence it is very important to rebalance.

Rebalancing is a form of risk management that


will improve the investors risk-adjusted returns
over time.
It involves buying and selling a portion of one’s portfolio in order to set the
weight of each scrip back to its original state.

If an investor fails to rebalance, the more volatile scrip’s in the portfolio will


tend to take over and increase portfolio risk. 

Assuming the investor chooses the smarter option of rebalancing at the end of
year 1, he will have to buy or sell the shares in this order to ensure that the
portfolio remains equal weighted.
As can be seen the investor bought 89 shares of PNB to make up for the lost
weightage and sold 39 shares of BOI to reduce its weightage within the
portfolio.

Minor adjustments were made in case of other shares as well.

Rebalancing allowed the investor to earn a return of 11.9% on his portfolio, a


2.7% (11.9 – 9.2) improvement compared to him when he had not rebalanced.

This is because he now has more exposure to PNB whose prices increased
significantly during the year and less exposure to BOI whose price moved by only
5%.
Nobody can predict with certainty the future returns of a security, past
performance is almost never an indication of future performance.

By trimming back on winners and buying laggards, an investor is not only


“buying low and selling high”, a sure shot way to make money, but also
reaping the full benefit of diversification.

When & How to Rebalance?

There are 3 basic strategies one can adopt to decide when to rebalance a
portfolio:

Time-only rebalancing strategy : rebalanced at regular intervals like quarterly,


semi-annually or yearly. 

Regardless of how much or how little weights of constituents within a portfolio


drift from their target, rebalancing will be done only at a pre determined time. 

Determining the frequency of rebalancing depends mainly on how much risk


an investor wants to take, an investor who wants to avoid risk will rebalance more
and vice versa.

Threshold-only strategy : rebalancing the weights of the portfolio only if they


drift away from the weights set on day 0 by a predetermined margin, like 2%,
5% or 10%.

The frequency of rebalancing is irrelevant and might happen as regularly as once


every month or once every 3 years.

Time and threshold : rebalanced on a scheduled basis (monthly, quarterly or


annually) only if its weight has drifted away from the weight set on day 0 by a
predetermined minimum rebalancing margin, such as 2%, 5%, or 10%.

If at the time of rebalancing, the portfolio’s weights have deviated by less than
the predetermined margin the portfolio will not be rebalanced.
If the portfolio’s weights drifts by more than the minimum margin at an
intermediate time period, the portfolio will then not be rebalanced.

Process of how a portfolio should be rebalanced.


STEP 1: Recording target portfolio mix and target rebalancing schedule

Record the total cost of each security and the total cost of the portfolio

Decide on the rebalancing strategy to be adopted- Time and


threshold recommended.

let’s assume a margin of 10%, i.e

if the weights change by more than 10% portfolio will be rebalanced.

The period of rebalance will be quarterly.

So if the weights change by more than 10% during a quarter, the weights will be
rebalanced at the end of the quarter.

STEP 2: Compare the actual weight with the target weight after 3 months
At the end of 1st quarter no rebalancing action is required, though weights of
shares have moved, they are within the margin.

We can see that SBI and Allahabad Bank have breached the 10% margin and
hence the portfolio will have to be rebalanced.

STEP 3: Buy and/or sell shares to rebalance


Portfolio Ratios
PE ratio of a company is the ratio of the share price of a company to its earnings
per share.

Portfolio’s can also have PE ratio. 

Total net worth is the price of the portfolio or the numerator part of the PE
ratio.

Cumulative earnings of all the companies is the denominator part.


One way of interpreting a portfolio PE is by comparing the same with
the benchmark PE.

If a portfolio PE is higher than the benchmark


PE, then one can interpret the portfolio as being
overvalued when compared to the benchmark
One can also compare the current PE of the portfolio with its historical value to
understand whether the portfolio is undervalued or overvalued.

If a portfolio has more companies growing at a fast pace, then PE ratio of the
portfolio can be high as these companies usually are expensive compared to
the rest of the market.

If the portfolio companies have had weak total earnings, the total PE ratio
could be inflated because of low denominator.

Hence one has to closely inspect the portfolio companies before drawing any
conclusion about portfolio PE ratio.

Portfolio Dividend Yield

A stock’s dividend yield measures its annual dividends as a percentage of its


price.

A portfolio’s dividend yield represents the total


annual dividend income from the portfolio as a
percentage of the current net worth of the
portfolio
A high dividend yield number is good as it indicates that the investor received
more dividends from the companies in his / her portfolio.
So how does one know whether the dividend yield he / she has earned is high or
low?

Obviously either by comparing the portfolio dividend yield with


the benchmark dividend yield or by comparing the current dividend yield of
the portfolio with its’ historical numbers.

However one has to be careful before drawing broad conclusions about the
dividend yield of a portfolio.

A portfolio might earn low dividends due to a number of reasons.

Companies growing at a fast pace conserve cash and do not pay out dividends.

Companies making losses continuously might also not have spare cash to pay
dividends.

If the investor’s portfolio has a lot of fast growing companies or a lot of loss
making entities, dividend yield will be low.

However the first case is good for the investor because share prices of fast
growing companies also grow fast, thereby earning good return on investment.

Low dividend yield because the portfolio has a lot of loss making companies

will affect the investor 2 ways.

He/ she does not earn dividend income and

At the same time company’s share prices might also drop resulting in loss on
investment.

Hence investor should understand the portfolio companies better before


interpreting the dividend yield number.
Portfolio Beta
Beta is a measure of market risk.

If the beta of a stock is more than 1, it means stock moves along with the market
in the same direction and is more volatile than the market.

If the beta is less than 1, it means that stock is less volatile and not related to
the market

Similar to stock beta, a portfolio beta represents the volatility of the


portfolio.

However market risk – risk that is not specific to any single company and affects
all the companies in the market – is not diversifiable. 

A portfolio beta represents market risk.

Portfolio beta helps us understand the direction of the


portfolio movement and the strength of the portfolio
movement in comparison to the market

If the beta of the portfolio is more than 1, it means that the portfolio moves in
the same direction as the market and at a faster pace than the market.

Similarly if beta is less than 1 it means portfolio does not move in tandem with
the market.

So let’s assume imaginary portfolio X has a beta of 1.3.

Suppose the market is expected to increase by 1% on a particular day, portfolio X


can be expected to increase by 1.3% (1% * 1.3).

Similarly if imaginary portfolio Y has a beta of -0.8, then on a day market is


expected to increase by 1%, portfolio Y can be expected to decrease by 0.8%
(1% * -0.8).
Portfolio beta is the weighted average beta’s of the individual stocks of the
portfolio. 

Proportion of company’s weight in the portfolio can be used as the weight


when calculating portfolio beta.

So portfolio beta can be altered by changing stocks in the portfolio.

If the investor expects the market to go up over the next 1 year, then he can
add high beta companies to his portfolio to enhance portfolio returns.

On the contrary if the markets are expected to drop over the next 1 year, the
investor can load up his portfolio with low/ negative beta stocks thereby
protecting portfolio returns.

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