5 reasons why small investors should avoid stocks and buy mutual funds

Reason No. 1: Insufficient funds

Many small investors are unable to spare more than Rs 5000 or 10000 per month for investing. Such amounts are insufficient for investing in excellent stocks. Investors can at best buy only 25 shares of ITC, or 10 shares of HDFC.

Alternatively, they can buy 50 units of DSPBR Top 100 fund. The fund’s equity holdings include ITC, HDFC, TCS, Larsen & Toubro, Coal India, ONGC, ICICI Bank, Hindalco, Grasim, Bank of India, Bharti Airtel, Glaxo Pharma, Lupin, and many more stalwart stocks. 

Reason No. 2: Insufficent knowledge

Small investors have very little knowledge of how the stock market works, and what are the rules and criteria for success. They jump into the market feet first – attracted by stories of untold riches with very little effort. No wonder they end up losing big time.

Some never recover from the initial trauma, and quit the stock market for ever. Others plod along manfully, feeling happy if they can recover their losses after a few years. A handful eventually learn the ropes and end up with a decent retirement kitty.

It is much better to invest in a mutual fund, and leverage the knowledge of the fund manager.

Reason No. 3: Insufficient time

For most small investors, buying and selling stocks is a part-time activity that provides some extra money and thrills. But to become truly wealthy from one’s stock investments, one has to be engaged in it full time.

Why? Because one has to learn and monitor a variety of information – the economy, its particular cycle stage, inflation, interest rates, oil and other commodity prices, activities of FIIs and DIIs, quarterly results of individual companies, analysing annual reports, tracking promoter activities, their shareholding, and so on. Most investors have insufficient time to spare for such learning and monitoring.

The fund manager and his team get paid to do such monitoring on a daily basis. Benefit from their services.

Reason No. 4: Insufficent experience

It takes years of experience in the stock market to learn the intricacies of fundamental and technical analysis that would enable a small investor to distinguish between a good stock and an excellent stock. A good stock may give you decent returns over a couple of years and then fall from glory (think Pantaloon or Suzlon). An excellent stock – like ITC or HDFC – will provide superior returns year after year, and can be bequeathed to future generations.

Take a re-look at some of the stocks in the portfolio of DSPBR Top 100 fund (mentioned in Reason No. 1 above). That is an excellent portfolio selected by an experienced fund manager.

Reason No. 5: Insufficient risk tolerance

Almost inevitably, a stock falls in value when a small investor buys it, and rises in value when a small investor sells it. The result is usually panic, and a desperate desire to either recoup the loss or re-enter for more profits at the earliest. Without knowledge of her own risk tolerance, a small investor invariably sells too soon or buys too late.

Better leave the buying and selling of portfolio stocks to the fund manager, so you can sleep more easily at night.

Please note that a fund manager is human and can make errors in judgement. That is why it is important that you do a little research before selecting the fund you buy. Keep investing your monthly savings regularly in buying a fund through bull and bear markets. After a few years of regular investing, your investments are likely to grow considerably – and so will your experience. Then you can contemplate building a stock portfolio of your own.

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A Solution to the Exercise on Cash Flows

Last week’s exercise on Cash Flows drew a large number of readers, but, disappointingly, only 6 responses. That could be because of three reasons: (a) most readers did not understand the concept of cash flow; (b) readers felt shy about making an incorrect response in an open forum; (c) readers did not feel that cash flow is an important enough concept to break their heads over.

Now that the Sensex is on the upswing again after nearly 5 months of correction, the participation in various investment groups and chat boards have increased significantly. Many of the topics are nothing but a succession of ‘buy’ calls on stocks of various pedigree, mostly questionable, with a stop-loss 2 points below the ‘buy’ price and targets of 3 points and 5 points above the ‘buy’ price. Gleeful announcements follow that the first target has been hit and one should book 50% of profits!

If more young investors learned the basics – and let me emphasise that cash flow is one of the most important concepts any investor should learn – they would know how to make really big money, instead of being happy with a 3 point or 5 point profit in 2 days (which they don’t forget to annualise into huge percentage gains to ‘prove’ their stock-picking prowess).

Pardon the rant. Now a turn to acknowledge the 6 readers who had the interest and intelligence to read and understand the concept of cash flow, and the guts to attempt answers to the exercise. Well done. All of you are winners, because you can consider yourself a few cuts above ordinary investors, who jump into the market with no idea of what they are doing.

There were no ‘right’ or ‘wrong’ answers, because stock picking depends on individual preferences and risk tolerance levels. But a distinction needs to be made on the process one follows to take a decision about a particular stock. A special hat-tip to reader ‘TK’ for the most logical way of arriving at his decision. My anonymous subscriber’s response was the next best.

Just to recap the concept of cash flow, a positive number is an inflow and a negative number is an outflow. In cash flow from operating activities, a positive number is preferred. A business should not just generate profits, it must generate cash – not as an amount to be received at some future date (which is represented by a negative cash flow). Often, the profit figure is an accounting sleight of hand. So the negative cash flow never turns positive. On this aspect alone, Company ‘A’ beats ‘B’ and ‘C’ hands down. (Cash flow can be fudged also – but will show up in the Balance Sheet. This is what Ramalinga Raju did at Satyam, and his auditors ignored or overlooked it.)

‘A’ has also been investing regularly in expanding its activities, as can be seen from the negative cash flow from investing activities. Negative cash flow here is actually good for the business. However, if the cash generated from operating activities is insufficient – as was the case in ‘06, ‘07 and ‘09 – there is no option but to resort to borrowing. Note that the cash flow from financing activities were large positive amounts. In the two years (‘08 and ‘10) that substantial cash was generated from operations, the company paid back some of its debts – as can be seen from the negative cash flow from financing activities. A sign of financial prudence.

What can’t be made out from the abridged cash flow statements is the total debt burden and interest payments. If the debt/equity ratio (which is calculated from the Balance Sheet) is more than 1, then the company may get into a debt trap after one or two bad years. Another metric to check is whether interest payment exceeds net profit (which can be observed from the P&L statement). If it does, then the banks are benefitting more than investors.

As far as ‘B’ and ‘C’ are concerned, both fail the test because I only consider companies suitable for investment if they have positive cash flow from operating activities in at least 4 of the past 5 years. Of the two, ‘B’ is better because it has achieved higher profits on lower levels of debt (as can be seen from the cash flow from financing activities). Also, its profits are growing, whereas profits of ‘C’ are stagnating.

Please appreciate that this particular analysis is a bit simplistic because the cash flow statements are abridged. However, it provides a good overall picture for short-listing potential companies to invest in. A more detailed analysis of the Balance Sheet and P&L statement should be conducted before taking a ‘buy’ decision.

Ideally, a company should not only have positive cash flow from operating activities, but also positive free cash flow. That means, cash flow from operating activities should be more than enough to fund any capital expenditure. Such is the case with many FMCG companies. One reason why FMCG is my favourite sector.

(Note: Company ‘A’ – Aurobindo Pharma; Company ‘B’ – IVRCL Infra.; Company ‘C’ – Pantaloon Retail. No particular reason for picking these three – other than the fact that they can be ranked based on their cash flow statement.)

How to read the Cash Flow Statement – Part 2

In last Tuesday’s post, I had covered the first part of the Cash Flow Statement – Cash Flow from Operating Activities. The next two parts will be discussed in this post.

Part 2: Cash Flow from Investing Activities 

To remain in business over the long haul, a company needs to grow. Without growth, a business will stagnate and eventually die or get acquired. But growth has a price. Cash has to be spent to buy land, machinery and related equipment, build factories and offices, acquire other companies, start subsidiaries or joint ventures, and make appropriate investments.

All of the above comes under Cash Flow from Investing Activities. You don’t have to be a genius to guess that this figure will be a (negative) one for most companies. Many mature companies, particularly those in the FMCG sector, don’t have much need for Capital Expenditure (i.e. spending cash on factories and equipment) because their rate of growth has slowed down.

Ideally, the depreciation amount in the Profit and Loss statement should be less than or equal to the amount of cash being spent in investing activities – because depreciation is meant to cover the notional loss due to wear and tear of the existing plant and machinery. If a company does not continuously spend on upgrading and modernising its facilities, it will not be able to compete with newer entrants who may have the latest technology and equipment.

The definition of Free Cash Flow is:

Cash Flow from Operating Activities – Capital Expenditure

This is a (negative) number for companies in their early growth stage, when cash generated from core operations may be insufficient to cover the cost of capital expenditure. But for well-established companies, positive Free Cash Flow is an indication of financial health. The more positive Free Cash Flow a company can generate, the easier it is for them to expand, acquire, pay dividend or buy back shares, and pay off loans.

Part 3: Cash Flow from Financing Activities 

What if a company has (negative) Free Cash Flow, or still worse, has (negative) Cash Flow from Operating Activities? Where will they get the cash to pay their suppliers, interest to banks for any loans taken, and for growing the business?

They can either resort to more borrowings, and/or issue more shares. If such companies are showing a net profit, then they are also expected to pay dividends to their shareholders. All inflows and outflows of cash due to loans, share issues, share buybacks, dividend payments come within Cash Flow from Financing Activities.

Financial prudence should dictate a company’s growth plans. As a thumb rule for selecting good stocks, about 60-70% of the Cash Flow from Investing Activities (Part 2) should be funded by positive Cash Flow from Operating Activities (Part 1); the balance 30-40% should come from Cash Flow from Financing Activities (Part 3).

Many companies forget the simple adage that one should cut one’s coat according to the cloth. They may even have positive Cash Flow from Operating Activities, but their ambitious growth plans require far more cash than they can afford. They resort to frequent borrowings and share issues in the hope of reaching the top quickly. One or two bad years can bring such companies down to their knees. Pantaloon and Suzlon come to mind.

(Note: The financial health of banks and financial institutions can’t be judged by analysing the Cash Flow Statement alone – because they need to borrow cash to give loans, and invariably have negative Cash Flow from Operating Activities. Price to Book Value and Return on Assets are better measures for such companies.)

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