Is it worth investing in tax-saving bonds?

To reap the benefits of high interest rates prevailing in the market, many investors have been booking profits in the stock market and parking the proceeds in bank fixed deposits (FD). But the interest received from bank FDs is taxable. It is that time of year when advance taxes need to be paid. Shouldn’t investors be looking at saving taxes by investing in infrastructure bonds and tax-saving bonds?

In this month’s guest post, Nishit explains the basic difference between infrastructure bonds and tax-saving bonds, and recommends that investment in tax-savings bonds is definitely worth considering seriously.

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Tax-saving bonds are the flavour of the month. Let us try and ascertain if they are worth buying. Earlier in the year, Infrastructure Bonds were introduced. Some of those bond issues are still open. How are the current tax-saving bonds different from the Infrastructure Bonds?

For starters, to avail tax breaks in the infra bonds, the limit up to which one could invest was Rs 20,000. This Rs 20,000 would be deducted from your taxable income for the year. This would save about Rs 6,180 in the highest tax bracket. The interests from these bonds are not tax free and would be added to one’s taxable income in subsequent years. The interest rates offered were in the rage of 8-8.25% per annum.

The tax-savings bonds being offered now are of a different type. In these bonds, a retail investor can invest Rs 1 lakh for a period of 10-15 years. These bonds are offered by various government undertakings like REC, NHAI, PFC and are hence safe investments. The bonds offer tax free returns as the interest is not taxable. The interest rates are about 7.93% to 8.32%. This means if Rs 1 lakh is invested, then upto Rs 8,130 interest which one gets annually is not taxed. Over a period of 10 years, this amounts Rs 81,300 which is not taxed. To get equivalent returns from a taxable bank FD, the interest rate one should get is about 11.5%. There is no bank FD which falls under the ‘safe category’ offering such returns.

The REC issue is due to get closed on the 12^th of March, 2012 and one can definitely look at further similar issues hitting the markets. The benefit of such issues over the infrastructure bonds is that one can save a much larger amount of tax.

Details of REC issue as below:

There is another tax free bond in the market! REC or Rural Electrification Corp. Ltd. is going to raise Rs 3,000 Crore by selling tax free secured redeemable non-convertible bonds . The subscription will open on March 6 and close on March 12 , 2012. While it is being sold that the interest on the bond will be tax free, it is important that subscribers should know other aspect of this tax free bond issue.

Credit Rating : “CRISIL AAA/Stable” by CRISIL, “CARE AAA” by CARE, “ICRA AAA” by ICRA & “Fitch AAA (Ind)” by FITCH.

The Company has confirmed the following interest rates:

Tenure of the bonds	Other than Category III investors (i.e. QIBs & Corporates and Individuals/HUFs investing > 1,00,000)	Category III investors (Individuals and/or HUF investing upto Rs. 1,00,000/- in the issue)
10 years	7.93%	8.13%
15 years	8.12%	8.32%

Individual/HUF limit reduced due to a notification dated February 14 issued by Central Board of Direct Taxes (CBDT) clearing the issue has said that “any individual investing over Rs 1 lakh will be classified as high net worth individual (HNIs)”.

• Bucket size: The issue size would be Rs. 3000 Crores (shelf limit)
• Minimum Application: Rs 5000/-(5 Bonds of Rs 1000/-) and in multiple of Rs 1000/-
• Issuance Mode - Demat only
• Listing at BSE only
• Interest Payment – Annually
• Allotment on first come first served basis.
• Interest on the refund money will be at rate of 5% p.a.

Category of investors	Bucket size
Category I (includes QIBs and Corporate)	50%( 1500 Cr)
Category II (Individuals/HUFs investing > 1,00,000)	25% (750 Cr)
Category III (Individuals/HUFs investing < 1,00,000)	25% (750 Cr)

Tax Benefits:

1. The income by way of interest on these Bonds shall not form part of total income as per provisions under section 10(15)(iv)(h) of I.T. Act, 1961;
2. There shall be no deduction of tax at source from the interest, which accrues to the bondholders;
3. As per provisions under section 2 (29A) of the I.T. Act, read with section 2 (42A) of the I.T. Act, a listed Bond is treated as a long term capital asset if the same is held for more than 12 months immediately preceding the date of its transfer. Under section 112 of the I.T. Act, capital gains arising on the transfer of long term capital assets being listed securities are subject to tax at the rate of 20% of capital gains calculated after reducing indexed cost of acquisition or 10% of capital gains without indexation of the cost of acquisition;
4. Wealth Tax is not levied on investment in Bond under section 2(ea) of the Wealth-tax Act, 1957.

Note: The investment limit for Category III investors has been increased from Rs 1 Lakh to Rs 5 Lakhs.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

Is the Q3 GDP growth rate of 6.1% a good or a bad number?

The short answer to the question: It depends on your viewpoint. Such a GDP growth number can not be seen in isolation, but in comparison with what has happened before and what is happening elsewhere.

Here are a few reasons why the number is good, and a few more reasons why the number is bad. The idea is not to confuse readers, but to provoke thinking and debate.

Reasons why Q3 GDP growth of 6.1% is good

If you look at the growth figures in some of the developed economies – particularly those in the Eurozone where even a 2% growth figure is considered good – a 6.1% growth figure should be celebrated with fireworks and champagne. The stark difference in growth figures is one of the reasons FIIs are investing big sums in our stock market.

High growth usually leads to inflation and therefore, high prices for goods and services. A more moderate growth figure has helped to tame inflation to a certain extent.

The Q4 GDP growth figure is unlikely to be much higher, but things are likely to improve from here on as there is usually a spurt in spending by the government sector to utilise left over funds from the previous year’s budget. In other words, the economic cycle may be bottoming out – which it usually does a few months after the stock market bottoms out.

Reasons why Q3 GDP growth of 6.1% is bad

This was the lowest growth figure in nearly 3 years, and almost 35% lower than the heady figure of 9.5% growth seen 5 years back.

There is evidence of economic slowdown everywhere – particularly in the manufacturing sector. Even services sector is slowing down. If growth doesn’t pick up soon, the FIIs may just pull out their money and invest it elsewhere.

Government’s fiscal deficit target for the year has already been exceeded in the first 10 months. That, coupled with the rise in oil prices, means that inflation may rear its ugly head again. The RBI may feel constrained to leave interest rates at the current high levels, or reduce it only marginally. That in turn will lead to slow growth in the next financial year.

Did the stock market over-react to the 50 bps CRR cut by RBI?

The short answer to the question is: Yes. The CRR rate cut is good news, but not great news. Great news would have been a cut in the repo and reverse repo rates. Now, the long answer.

Imagine that you are a farmer in central India, and it is the middle of April. With poor access to irrigation facilities, your crop is dependent on the monsoon rains. Your cousin from the nearby town comes to visit you and mentions that it was announced on the TV that monsoon may set in a week early in the middle of June instead of the third week. No doubt, that would be good news. But the rains will still be two months away.

RBI's announcement is somewhat similar. The CRR rate cut is an indication that repo and reverse repo rates may be reduced two months down the road. So, today's high volumes may be a sign of a buying climax.

What is the CRR and what purpose will be achieved by cutting it from 6% to 5.5%? Cash Reserve Ratio (CRR) is a percentage of the total deposits in a bank that has to be maintained as a 'reserve' with the RBI. It is one of the monetary instruments used by the central bank to regulate the money supply in the financial system.

Due to the aggressive interest rate increases by the RBI to contain inflation, growth has started to slow down. In fact, the RBI has now set the GDP growth target for 2011-12 at 7% - down from earlier revised target of 7.6%. Much lower than the glory days of 9-10%. India Inc. have been complaining that growth was being sacrificed to control inflation. Now that inflation rate has finally started to moderate, RBI has taken the first step by increasing the liquidity in the financial system.

How does it work? Let us say, a bank has Rs 10,000 Crores as deposits. A 6% CRR implies that Rs 600 Crores have to be maintained as a 'reserve' with RBI. That means, the bank has access to only Rs 9400 Crores that it can give out as loans. A 50 bps (i.e. 0.5%) cut in the CRR leaves the same bank with access to Rs 9430 Crores to deploy gainfully. On the extra Rs 30 Crores, the bank can expect to generate an additional Rs 3 Crores in profit.

The overall cash infusion into the banking system is expected to be about Rs 32,000 Crores, which can be loaned out to generate a profit of say Rs 3200 Crores. Not a small sum, but not a king's ransom either. Now you know why the bank stocks rose today. But that is the theoretical view point. What is likely to happen in real life?

Is India Inc. going to break down the doors of banks to apply for loans? Highly unlikely. Remember that the interest rates remain just as high as it was two months back, when no one was taking loans and were postponing capital expenditure. Banks are also struggling to contain their NPAs and have become quite rigid in doing due diligence before handing out loans. Add to that the likelihood of the inflation fires getting stoked by the excess liquidity in the system. There is also 'hidden' inflation due to large subsidies.

All in all, definitely not a cause for celebration. The RBI governor clearly put the ball in the government's court by pointing out that fiscal profligacy is one of the major causes of inflation. Unless core inflation falls further, do not expect a cut in the repo or reverse repo rates in a hurry.

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5 reasons why this is a sucker’s rally and not a change of trend

P. T. Barnum, a 19th century American circus owner, had apparently said: “There is a sucker born every minute.” Translated into English, that means that the world is full of gullible people. Any idea, however ridiculous and unbelievable it may be, is sure to find a few takers.

Crazy ideas - from ‘the world is flat’ and ‘the sun moves around the earth’ to ‘Suzlon is the next GE’ and ‘RJ is the Warren Buffett of India – follow his portfolio if you want to become rich’ – always find believers (a.k.a. ‘suckers’).

So, what is a “sucker’s rally”? It is a sharp price rise in an index or a stock without the support of fundamentals – usually during a bear market. Here are 5 reasons why the current rally in the Sensex and Nifty indices is a sucker’s rally:

1. There is a ‘gut feeling’ among small investors that the worst is over. Gut feelings are seldom right, unless the guts belong to some one called Warren Buffett. Even Buffett is known to make mistakes. Keep your guts where they belong. Use your brains instead. The problems in Europe haven’t been solved yet. China’s economy is struggling with slower growth. The worst may not be over yet.

2. A general consensus among market players is that RBI may start reducing rates soon; even if the interest rate remains where it is, there is likely to be a cut in the CRR to increase liquidity. The RBI has not indicated any such thing. They have only paused in hiking interest rates further. That means, interest rate remains just as high as it was a month ago when the Sensex and Nifty hit their lows. Stock markets can’t sustain in a high interest rate environment.

3. Though food inflation has started coming down, it may be more due to a high ‘base effect’ and seasonal availability of vegetables. Core inflation has moderated a bit, but still remains high. RBI has made it quite clear that controlling inflation is their top priority. Unless core inflation drops below 5%, interest rate cuts may not be effected. Inflation won’t come down as long as the government spends recklessly on various schemes to buy votes.

4. The government’s policy inaction will continue till the annual budget is announced in mid-March – thanks to the impending elections in five states. The only bit of good news for foreign investors in recent times has been the Supreme Court’s judgement in the Vodafone case, stating that the Income Tax department has no jurisdiction over a transaction between two overseas entities. But that judgement is more in the nature of removing an unnecessary irritant than paving the way for any fresh investments. The government has to be far more proactive on the policy front to change the commonly held perception that it is bureaucratic and inept.

5. Technically, both the Sensex and Nifty are in 14 months long bear markets. Bear markets (and bull markets) don’t turn around suddenly. They usually form some sort of a reversal pattern, which takes a few weeks to a few months to form. No such reversal pattern is visible as yet.

The recent spate of FII buying has begun to attract inexperienced small investors who don’t want to miss the bus. Technical indicators are looking overbought. The stage seems set for the big boys to get out. The suckers may get stuck with shares bought at higher prices.

Why did the stock market fall despite a good IIP number?

India’s Nov 2011 IIP (Index of Industrial Production) came in at 5.9% – higher than the consensus estimate – raising hopes of a quick return to the growth path. Considering the Oct 2011 IIP of –5.1%, there was a huge 11% swing month-on-month.

The stock market should have celebrated by spiking higher – specially since both the Sensex and Nifty are in the midst of rallies from their recent bottoms. Instead of doing the obvious by rising, both indices lost ground. Not much, but enough to cause consternation among small investors.

What is going on? Is this just the way Mr Market behaves to separate investors from their hard-earned money?

There can be a few logical explanations, which are mentioned below:

1. Both the Sensex and Nifty are in the midst of prolonged bear markets. Good news tend to get ‘discounted’ quickly and bad news causes renewed selling during bear markets.

2. Infosys – which is generally considered to be one of the bellwethers of the Indian stock market – announced better than expected Q3 results, but disappointing Q4 guidance and got hammered. Its high weightage in both indices caused the fall.

3. Oct 2011 IIP number was unusually low – but one must remember that it was a festival month (Navratri and Diwali), which meant lower production days due to the holidays. Nov 2011 IIP was comparatively much better, but some of the new orders may be due to inventory replenishment. Lower growth usually leads to inventory draw-downs (companies tend to let their existing inventory get depleted almost completely before placing new orders).

4. Technically, both indices retreated after facing twin resistances from their 50 day EMAs and DTLs (refer last Sunday’s post on Sensex and Nifty chart patterns).

5. All of the above.

Stock markets don’t necessarily move according to logic. In the short-term, sentiments can, and often do, overrule the fundamentals. So can a rush of buying or selling by the FIIs. What should small investors do?

Remember an old saying: “Buy the rumour; sell on news.” There is no better example of that maxim than today’s price action in the TTK Prestige counter. The company announced impressive Q3 results, but the stock lost more than 7% after the ‘good news’!

The stock market is in a state of flux. After 14 months of down trend, small investors are becoming impatient to buy in the hope of a trend reversal soon. Please be aware that interest rate is still high. So is inflation – though food inflation has turned negative. Stock markets don’t reverse trend till the first few interest rate cuts happen.

There is a clamour for a CRR rate cut from all corners. If the Nov 2011 IIP figure is the reality, i.e. economic growth is back on track instead of what has been mentioned in point 3 above, then there is no reason for the RBI to cut the CRR – let alone cut the interest rate. A rate cut may stoke the inflation fire.

In other words, there is no need to turn bullish yet. Await Q3 results of the big guns and RBI’s policy announcement on Jan 24. You may miss the absolute bottom by being conservative, but in a bear market it is better to be safe than sorry.

RBI pauses interest rate hikes – why did the stock market dive?

Stock markets and interest rates have a love-hate relationship. Markets love low interest rates, but detest high interest rates. ‘Low’ and ‘high’ are relative terms. As a very rough thumb rule, a Repo rate of 5% or lower can be taken as a ‘low’ rate; 7% or higher can be considered a ‘high’ rate.

In Jul ‘08, the Repo rate (the interest rate payable by commercial banks when they borrow money from the RBI) had peaked at 9% – more than 6 months into the previous bear market that lasted from Jan ‘08 to Mar ‘09. Thereafter, Repo rates and Reverse Repo rates (interest rates payable by RBI when they borrow money from commercial banks) were gradually reduced till the Repo rate hit a low of 4.75% in Apr ‘09.

By Mar ‘09, when the Repo rate was at 5%, the stock market reversed direction and started rising. The ‘lag’ effect of interest rate changes are evident from the above data. Bear markets start well before interest rates hit their peak; bull markets start before interest rates drop to the bottom.

The next increase in the Repo rate came only in Mar ‘10, when it was raised from 4.75% to 5%. The bull market was already a year old by then. Thereafter, 12 more rate increases – the last of them in Oct ‘11 – took the Repo rate to a high of 8.5%. By then, the bear market from the top of Nov ‘10 was almost a year old.

Why do stock markets hate high interest rates? Because the cost of doing business increases for every one, and profits take a hit. Capital expenditure is postponed, which hurts growth and in turn, hurts profits. When earnings decrease, EPS reduces. P/E ratios become higher, which induces selling of stocks and shifting of investments to bank fixed deposits at high rates.

Two months back, RBI last increased the Repo and the Reverse Repo rates by 25 basis points (0.25%). The stock market had expected the hike, but appeared to celebrate the news by moving up. That seemed to go against logic. Stock markets are supposed to hate high interest rates. What may have caused the celebration was a hint by the RBI that they may not raise rates further if inflation rate started to moderate.

Inflation rate has started to drop, though it continues to remain high. Food inflation has fallen quite remarkably – whether due to seasonal reasons or high ‘base effect’ or both. The high interest rates caused GDP growth to slow down and de-growth in IIP (Index of Industrial Production). So, it was no surprise that RBI left the interest rates unchanged, and hinted that rates may be lowered henceforth to spur growth. Instead of celebrating, the stock market dived – again appearing to defy logic.

What happened? Many market players had expected a cut in the CRR (Cash Reserve ratio – the percentage of total deposits that commercial banks have to maintain in cash) to inject more liquidity into the financial system. But a combination of an inflation rate that is still high and a fast depreciating Rupee against the US dollar may have forced RBI’s hand in keeping the CRR in tact. That perhaps caused disappointment that led to the sell-off today.

During a bear market, the slightest bit of ‘bad’ news causes a disproportionate amount of negative sentiment. Even if the news isn’t bad for the long-term but appears to be bad in the short-term gives a good enough reason to sell. The opposite happens in bull markets, when the slightest bit of ‘good’ news sends the stock indices soaring. That is an unlikely occurrence at least for another 6 months. Till interest rates are reduced significantly, the bulls will not return.

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Notes from the USA (Nov 2011) - a guest post

The US economy is slowly recovering from a massive downturn. To boost growth, interest rates have been maintained at near zero levels. Despite two rounds of Quantitative Easing, growth hasn’t picked up as expected. So, inflation has also remained low.

India has the opposite problem. High inflation has been fuelled by strong growth. To contain inflation, interest rates have been increased. But the inflation adjusted fixed income returns are negligible in both countries. In this month’s guest post, KKP gives his views on how to truly get rich by boosting your inflation-adjusted returns.

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Feel Rich Only with ‘Real’ Inflation-Adjusted Net-Worth-Growth

The 8^th wonder of the world is ‘% rate compounding’. In simple terms it means that growth in money based on money-making-money. In the US schools, I have taught kids how to become a millionaire by starting a part-time job at age 16 and putting $100 per month into an interest bearing account that multiplies money over the next 20-40 years of their life. On a side note, it is very interesting how many millionaires there are in the US, and in general, their profiles/habits/investment-styles (Google search for this info).

Well, the same effect of compounding works against us when it comes to inflation. In mainstream economics, the word ‘inflation’ refers to a general rise in prices measured against a standard level of purchasing power. Previously the term was used to refer to an increase in the money supply, which is now referred to as expansionary monetary policy or monetary inflation. Inflation is measured by comparing two sets of goods/services at two different points in time, and computing the increase in cost not reflected by an increase/decrease in quality. This is something that emerging economies grapple with during their entire growth phase, and we call that ‘growth pains’.

The inflation rate in India was last reported at 10.1% in Sep 2011. From 1969 until 2011, the average inflation rate in India was 7.99% reaching an historical high of 34.68% in Sep 1974 and a record low of -11.31% in May 1976 (strange but reported as negative). Many banks in India are offering 9% to 10% FD rates today, with corporate FDs getting much higher rates (at higher risk levels). Well, that is just a net 1% to 2% rate of return (after inflation). The chart below shows fluctuations in inflation within our Indian (a.k.a emerging) economy over the past three years. So, money is growing at a net-rate of only 1% to 2% in FDs or FMPs.

The US is about to move from a highly controlled non-inflationary environment into a high-inflation environment due to the non-stop printing of treasury bonds (no gold collateral is needed as everyone knows). Inflation basically makes you shell out more dollars to buy the same product (same quality and quantity assumed). So, one needs to earn more as a result - just to keep up with the inflation. Now, what really happens with inflation is a reduction in the value of the currency. So, as an example, one needs more dollars to buy an asset like a home, a gold coin or gallon of milk. See the chart below and study it for a couple minutes. Has the S&P500 really grown even though our Mutual Fund account might be showing net-growth-in-value? Maybe, slightly!

On the other hand, companies pay employees more every year to keep up with the inflationary environment, and over a period of time everyone feels good that they were earning $24,000 per year in 1996 or 2001, and now, they are earning $50,000 per year. But, when you measure it in terms of the depreciation in the dollar (caused by inflation), are they really better off with the higher salary? Or, would they rather have a no-inflation environment and get paid slightly more for their growth in experience and skills?

So, compounding effects of inflation in every economy around the world is really killing the value of the underlying savings that we hold, unless we keep growing that money ABOVE the inflation rate on a consistent basis. So, in India, if one had Rs 10 Lakhs in 2001, and now has Rs 21.58 Lakhs, then at the average inflation rate of 8% per year, their net-growth in wealth is a BIG ZERO. Same zero growth applies if one had Rs 1 Crore in 2001 and now has Rs 2.158 Crores. Yet, all of us feel good about the growth in the ‘total raw value of our accounts’.

Emerging economies give a lot of people a false sense of security that they have grown their income or assets by a huge amount over time, but one needs to beware of the 8^th wonder of the world working in ‘reverse’. India is going to generate the largest population of ‘middle income earners’, but one has to consider what a ‘real middle income level’ is, as inflation rate is eating away a lot of the increased income. As a result of the growth in the underlying Indian economy, a lot of low income earners will start feeling like middle-income-families, but for many it is a false sense of hope and feeling. Beware and generate a Return on Investment (ROI) way above inflation through a mixture of Stocks, Bonds, Real Estate, Commodities, FMPs and FDs.……That is the only way to feel rich and get truly rich!

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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.

Spreading some good cheer in a gloom and doom market

You haven’t misread the title. I do intend to spread some good cheer on a day when the Nifty fell by nearly 100 points and the Sensex tanked by more than 300 points. Many large-cap stocks are sliding, which means the correction in the indices are not yet over. 

Many readers may think – specially after reading my recent posts and comments - that I am a perennial bear who advises caution during bull phases and staying away during bear phases. They won’t be too far off the mark in their assessment. Over the past five years, I have been a net seller in the markets.

But that doesn’t make me a bear – more a realist. After 25 years of investing in the stock market, I have learned from experience that a bullish stance causes more losses than a bearish stance. Warren Buffett’s two investment rules should always be remembered:

• Rule No. 1: Never lose money
• Rule No. 2: Never forget Rule No. 1

The trick to long-term wealth building is not to try and make a lot of money in a short time, but to ensure that your losses are taken quickly and kept to a minimum (through appropriate use of stop-loss levels) and profits should be allowed to run.

OK, enough pontification for today. Now, to the subject matter of today’s post. In a recent article in MoneyWeek,  author Cris Sholto Heaton made the following comments that may sound like music to the ears of small investors:

• India's inflation is too high. That's been caused by growth running too rapidly for the amount of spare capacity in the economy. So if you want to bring prices under control, you're going to have to curb growth for a bit.
• Ultimately, if EM governments are willing to act to slow their growth at this stage of the cycle, it's healthier for their economies in the long run.
• This is the normal cycle. Growth peaks amid rising inflation, slows as interest rates rise, and then can begin to pick up again as the central bank loosens policy.
• EM policymakers are likely to be able to declare inflation beaten for this cycle over the next three months or so. Most can then begin loosening policy. And as long as Europe avoids the very worst outcomes (a bad outcome is a foregone conclusion at this stage), EM growth is likely to pick up again within the year.
• It's been a tough five years for EMs. We've seen the global financial crisis and the eurozone crisis, both of which have encouraged investors to flee to safer assets. Yet over this period, the MSCI Asia ex-Japan is still handily ahead of the S&P 500.
• EMs wobble more when inflation gets high and interest rates start to bite. And they certainly sell off harder during a panic. That's what we've seen in 2011.
• But the other side of this is that they perform much better when growth is strong and they're likely to do better over the course of the economic cycle. So while the news is unlikely to get any cheerier in the next few months, it should be setting EM investors up for a much better 2012-2013.

I thoroughly endorse the authors views.

Investing strategies in inflationary times – a guest post

The business channels and pink papers have been obsessive about high inflation in the Indian economy and the consequent rise in interest rates – and well they should be. The government doesn’t seem too perturbed about the deleterious effect that high inflation causes – not just to GDP growth, but also to the wallets of common citizens.

During such times, savings and investments may be farthest from people’s minds as they struggle to make both ends meet. However, there are some comparatively less risky investment opportunities that smart investors can avail of – and Nishit discusses them in this month’s guest post.

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Inflation is rising, cost of loan repayments (EMIs) is going up and jobs are getting lost. How does a common man deal with such a situation?

Government bond yields have almost reached 9%. This means interest rates may rise further in the times to come. EMIs may go up if the RBI hikes the Repo rate, which is currently at 8.5%. In the case of loans, it is best to pre-pay some amount rather than letting the tenure increase. Many people will not get a tenure extension if their tenure has reached the maximum limit of about 25 years.

This is a good time to lock in your savings in high yield fixed investments. Non Convertible Debentures of L&T Finance gives an yield of about 10%. Other fixed income investments like Bank FDs should be utilized to avail of high interest rates. A SIP can be started in a Gilt fund. The interest rate cycle is about to peak soon and Gilt funds are likely to give good returns.

The recently increased limit in PPF investments from Rs 70,000 to Rs 1 lakh, and the higher rate of PPF return of 8.6% is a wonderful opportunity and should be made use of by small investors.

The markets are headed downwards. This scenario is likely to remain till interest rates start moving down. At every decline to key support levels, one can add blue chip shares to the portfolio keeping a 5 years horizon in mind. Supports for the Nifty are at 4700, 4300 and 3700.

Gold as an investment can be looked at only when the previous high of US $1900 per oz is taken out, or near the support level of US $1600 per oz.

For astute investors, cash is king. In a slow GDP growth environment, if one is willing to put down cash then real estate as well as automobiles may be available at good discounts. Plummeting car sales indicate that good cars may soon get sold at discounts just to clear off the inventory and keep the assembly lines working.

This is a great time for an investor to build an entire new portfolio. The portfolio should comprise of fixed income instruments, stocks, commodities and real estate. A proper balance of allocation to these assets will generate wealth going forward.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

What if the stock market remains in a down trend for another year?

The Sensex and Nifty indices had touched their peaks one year back. Since then, both indices have been in down trends – neither falling a lot, nor rising much during counter-trend rallies. A gradual drift downwards that has all but sapped the bullish energy of small investors.

Several rounds of interest rate hikes by the RBI have failed to restrain rising inflation, but has started affecting economic growth. The high interest rates have led to postponing or cancelling of capital expenditure by companies, which in turn has affected the order books of capital goods makers, and engineering and construction companies.

The RBI had indicated the possibility of pausing the rate hikes if inflation begins to moderate. If the situation doesn’t improve within the next month or so, the RBI may be forced to hike the interest rate again.

Even if there is a pause in the rate hike, the already high rates are unlikely to be reduced immediately. Market sentiments do not turn bullish when interest rates are high and the GDP growth is slipping. It is quite possible that the Sensex and the Nifty may continue to trend downwards for another year.

However unlikely or pessimistic the above may sound, the path to success in stock market investing is to assess the surrounding environment at all times, and have strategies and plans in place. So, what can small investors do to prepare for another year of down trend in the stock indices?

The most important – and I can’t emphasise this more – is to have a financial plan, and based on it, an asset allocation plan. The queries I receive from small investors are mostly of these two types: “This stock is going up in a bear market – should I buy now or wait” or, “That stock has fallen a lot – should I wait longer or buy now”.

Hardly anyone asks me: “How do I make a financial plan” or, “How do I work out an asset allocation plan”. Without a plan, random buying and selling of stocks will lead to an unwieldy portfolio and very little returns.

Once plans are in place, a portfolio to suit the plans and the risk tolerance level of an individual can be built. A stock market in a down trend is the best time to build portfolios, because many good stocks are available at bargain prices.

What if you are one of those enlightened investors who already has plans and a well thought-out portfolio in place? Allow your portfolio to grow and prosper. How do you do that in a down trend? Mostly by not being overly aggressive. Within an overall down trend, individual stocks may perform better or worse. Use opportunities to book part profits or add to fundamentally strong stocks that have been beaten down.

Needless to say, whether to buy, sell or hold should be determined not by market fluctuations or gut feel, but by your asset allocation plan. When you book part profits, try to control the impulse of buying some thing right away. The high interest regime has its benefits in the form of higher bank fixed deposit rates and good returns from debt funds. Invest in them – as per your asset allocation plan.

Use the stock dividends that you receive at this time of the year to reinvest in your portfolio companies. Dividend reinvestment is like adding fertiliser to your plants. It helps them to grow better and faster.

Continue with your regular savings and systematic investment plans. There is a tendency of many small investors to stop investing when the markets are down. If you haven’t developed the skills to time the market (very few investors do), stick to your regular investments. Again, follow your asset allocation plan in a disciplined manner.

That is all there is to it. No magic formula will produce phenomenal returns in a down trending market. Just a boring, disciplined approach to planning, saving and investing for building wealth over the long term.

Notes from the USA (Sep 2011) - a guest post

Every one was expecting - or may be hoping - that Ben Bernanke would do something different to jump-start the US economy, after the failure of two rounds of Quantitative Easing. In typical Bernanke style, he had already taken much of the surprise element off the table by hinting at an Operation Twist. But when the actual announcement was made, global markets reacted negatively.

What exactly is this Operation Twist? Here is KKP's spin on it.

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Is the Fed Twisting the Future?


The US Fed announced Operation Twist.  What is the Fed ‘twisting’?  Most people that I have talked to (average Americans), do not even know this stuff was announced and going on (poll based on discussions with my neighbors at a party on Sat. Sep 24 ‘11)!


Basically, the Fed never does anything that affects the long term bonds or bond rates.  Rates are already so low that for those who wanted to refinance, they have already done so.  Fed always assumes that when it lowers the short term rates (which is the only thing in its control), the banks will react to the message that goes along with the rate change (at the FOMC meeting), and adjust the mortgage rates which are linked to the Prime Rate (usually).

The Fed also said that when mortgage-backed securities (MBS) that it owns right now is paid off, it will roll the money back into new securities that are linked to mortgages.  This means, it is also now trying to affect the mortgage rates, which would also go down with this move so that people can lower their mortgage payment (EMI) and spend the extra cash flow that they have received (and people here in the US sure do so).


The idea being that with lower interest rates on housing (long term rates of 10, 20, 25, and 30 year mortgage terms), people who are thinking about upgrading their homes would start going after a bigger loan and buy new homes.  Once the housing boom starts, there are tons of businesses that get the support needed and, hence revive the economy.   Homeowners who have a lot of home equity and are current on their mortgages may also be given an opportunity to refinance, freeing up cash flow that could be spent on buying a car, upgrading the home, and/or paying off other high interest loans.

The issue is that lower interest rates, or lower price of homes has not really triggered a buying frenzy.  That is because of two reasons.  First, banks are scrutinizing loan applications with a super-high-standard.  Everything has to be too perfect on the loan application, and any small element that points to risk, means that the loan officer rejects the loan.  Second, people who need new houses, and have one (or more than one) family member that may not have a job, or might have a weak job-income, or might not have the feeling of being secure in their current job, do not go out and make a big house commitment.  

A case in point is a single woman with a good job who wanted to buy a $325,000 home with $50,000 down payment, and $275,000 in loan was denied.  This is according to one of our neighbors who is livid about how the banks have tightened their purses for some unknown reasons.  Corporations, Banks and People (who have cash), are all ‘holding back’ due to the unknown future.  This is actually creating a ‘bigger’ issue than what it would really be.   So many of us are living normal lives in this recessionary environment, but we all have a fear of the future, which is what makes all of us spend less, conserve more, and wait for a brighter day (my personal situation is different, since I am capitalizing by buying real estate, which is exactly what the government is trying to do by keeping short term interest rates near zero).


Fed wants banks to loan money, which is why they had provided the TARP funding.  A lot of the TARP funding is being returned by the banks.  There are announcements that show this return of funds that is on-going, and even a couple of bank VPs told me this in confidence.  They are afraid to tap into it, loan the money, and lose profits (and capital) by loaning it to someone, specially if the economy gets worse.  In reality, the central bank requires banks to keep a certain level of reserves on deposit at the Fed.  Legislation passed in 2006 permitted the Fed to start paying interest on those reserves starting in 2011.  This requirement of reserves and ratios by the Fed makes the loan officers reluctant to give out loans to people with the smallest risk.

Group of 20 finance chiefs are pledging to address rising risks to the global economy and are “committed to a strong and coordinated international response to address the renewed challenges facing the global economy,” confirmed in a statement in Washington.  These officials cited “financial system fragility” and “heightened downside risks from sovereign stresses” among the threats to growth.  They said they will ensure banks are adequately capitalized and have access to liquidity, while reiterating an aversion to volatility in the currency markets.  This support model is what we need to keep our world spinning and continue e-commerce for the world to survive.  It is amazing that we are fearing a collapse when there is everything in abundance!


So, all in all, what is the ‘twist’ in the Operation Twist?  The twist really is that the Fed is trying to affect long term rates or mortgage rates without really dipping in any huge way into a QE3, which would have affected how investors around the world view the US.


Daniel Gross’s Upshot View: This move by the Fed is better than doing nothing. But there's no reason to think it will make the difference between unsatisfying and satisfying growth.   
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KKP (Kiran Patel) is a long time investor in the US, investing in US, Indian and Chinese markets for the last 25 years. Investing is a passion, and most recently he has ventured into real estate in the US and also a bit in India. Running user groups, teaching kids at local high school, moderating a group in the US and running Investment Clubs are his current hobbies. He also works full time for a Fortune 100 corporation.

Is the interest rate increase by RBI good or bad for investors?

Increasing interest rates are great for older investors and retirees. Their loans have mostly been paid off. They rely more on stable fixed income instruments, and higher interest rates are always welcome even if it isn't enough to cover inflation.

For younger investors, who can afford to take more risk and invest in the stock market or mutual funds, higher interest rate is bad news. Why? Because stock markets and rising interest rates are inversely proportional. Many market players use loans and margin money to invest. Their costs increase and make their leveraged investments unviable. Companies have to pay more interest, which affect their profits. They tend to hold back on capital expenditure, which affects growth.

As growth starts to slow down, the investment environment changes from bullish to bearish. Investors start to book profits, and move to safer havens like bank fixed deposits and gold.  The Sensex starts sliding which leads to more selling. It has a spiralling effect.

Doesn't the RBI know all this? Why are they increasing the repo and reverse repo rates again and again? Don't they know that growth is getting stifled?  The short answer is: they know what they are doing. But the RBI is caught between the devil and the deep blue sea. With inflation threatening to go out of control, increasing interest rates is the only tool they have - even if it causes a short-term growth slow down.

Unfortunately, the government is not playing its part. Bold policy changes are the need of the hour - FDI in multi-product retail, industry-friendly labour policies, unified tax regime are some of them. But such policies may upset the apple-cart - the nexus between politicians and their crony middlemen. The greater good is being sacrificed so a few people can get incredibly rich. Cutting out the middlemen will immediately put a tight leash on inflation. Interest rates can then be lowered and the economy will get back on the growth path. But that seems like wishful thinking.

What are the likely next steps? For the RBI, probably more rate hikes till the base effect kicks in and the inflation rate starts to moderate. For young investors, the stock market is unlikely to make new highs any time soon; so a good time to read up and, hone stock-picking skills. Lower levels of the Sensex may provide good opportunities to enter. For older investors and retirees, enjoy the high interest regime while it lasts.

A good time to feel ‘Gilt’y – a guest post

The stock market is in a strong bear grip. Even blue-chip stocks are feeling the heat and sliding down at the first hint of trouble. Mid-cap and small-cap stocks have been hit hard.

What can small investors do to protect their capital and get decent returns? In this month’s guest post, Nishit suggests that investors take a look at Gilt funds.

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Last month, the RBI hiked interest rates for the 11^th time since March 2010. The Repo Rate is now 8%. When will the RBI signal a pause?

The Repo rate is the rate at which the RBI provides short-term loans to banks. At 8%, it is about 1% below the peak which it achieved three years back. The hike in interest rates by about 3.25% has put pressure on interest rate sensitive sectors like Banks, Automobiles and Real Estate.

It’s a classical economist’s dilemma. If you hike interest rates you lower inflation but sacrifice growth. So, do you want high GDP figures or lower inflation? There is no correct answer. It has to be a mix of both.

The IIP numbers are high and so are the inflation figures. The latest Inflation number was a bit lower than the previous month, but continues to be high. Expect one more round of rate hike in September. The 1 year T-Bill is already quoting at 8.47%.

How do we play this rate hike in our favour? It is time to buy some Government Security (Gilt) funds. This is a time to very easily lock in about 20-25% returns over the next 12-18 months. This is based on the following factors: a) The government will eventually end the rate hike cycle starting with a period of pause and then a gradual reduction in interest rates; b) The 10 year bond yield will drop by about 200-300 basis points (2-3%) over a period of time.

Government Securities are freely traded in the Debt Market. A 10 year G-Sec having a face value of Rs 100 gives a yield of about 9%. After, say 12 months, the yield goes to 6%. The traded price of each bond goes up from Rs 100 to Rs 150, an increase of 50%. This is the optimistic best price scenario. Looking at entry and exit it is safe to expect about a 25% gain.

If we visit www.valueresearcholine.com, and do a search for Birla Sunlife Government Securities Fund, its best annual performance was from May 2008 to May 2009 when its yield was almost 26%. If we co-relate with the chart above, in June 2006, the Repo rate was 8% which went up to 9% before being brought down to 4.75% in April 2009. So, a net reduction of 3.25 % in the Repo rate was good enough to give the above returns.

Strategy:

Should we wait for further rate hikes before investing? It is not possible to always time the markets, so allocating about 50% of the investible funds now and rest after the September RBI policy announcement may be a prudent course of action.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

RBI tries a ‘shock and awe’ tactic to tame inflation

In what seems like a last-ditch effort to bring inflation under control, the RBI decided to use a ‘shock and awe’ tactic – even if it meant a slow down in growth in the near term – by raising the repo and reverse repo rates by 50 bps (i.e. 0.5%) each.

That may not seem like much, except that the consensus estimate in the market was a 25 bps hike. Some even hoped for a pause in the rate hike, as there were some signs of slow down in inflation and growth. The 50 bps increase came as a bolt from the blue, and the bears didn’t waste a moment in extracting a heavy toll.

Wikipedia describes the ‘shock and awe’ tactic as follows:

‘Shock and awe (or rapid dominance) is a military doctrine based on the use of overwhelming power, dominant battlefield awareness, dominant maneuvers, and spectacular displays of force to paralyze an adversary's perception of the battlefield and destroy its will to fight.’

Whether inflation will get tamed or not remains to be seen. But a 100 point drop in the Nifty and a 350 point fall in the Sensex may seriously hamper the bulls’ will to fight. However, the rate increase should not have come as a big surprise to readers of this blog. After the previous rate hike in June ‘11, this was my cautionary statement:

‘… without appropriate fiscal and policy measures to support the RBI's monetary tightening, inflation is not going to come down any time soon. … Which means more tightening and further increase in repo and reverse repo rates in future, while the governments 'addiction' remains uncured.’

I paid Rs 50 a kg for fresh ‘bhindi’ yesterday. People living in Mumbai and Delhi may laugh at such ‘cheap’ rates, but it is the maximum I have ever paid for a non-exotic vegetable in Kolkata. Now there is talk of allowing only 6 LPG cylinders per family per year at the ‘subsidised’ rate of Rs 405. Any additional cylinders will be billed at Rs 700 to mitigate under-recoveries of the oil marketing companies.

Even the current slightly moderated inflation rate – which the RBI is trying to bring down further with the 50 bps rate hike – is actually an artificially lower rate due to subsidised prices of diesel, kerosene and LPG. The actual rate is way higher.

So, be prepared for more rate hikes, more EMI payments, slower growth in the economy and a sliding stock market. The press conference of bank CEOs following the RBI announcement made one thing crystal clear. Things will get a little worse, before they get any better.

But there is a silver lining to every dark cloud. Shorter-term fixed deposit rates are likely to be raised soon. Time to take some profits off the table, and reallocate to fixed income. Looks like a very testing time for the bulls till Diwali.

RBI raises repo and reverse repo rates - again

Most economists and stock market analysts were expecting RBI to raise the repo and reverse repo rates by 25 basis points (i.e. 0.25%). So, the markets should have already 'discounted' the interest rate hike. Then why did the Sensex drop nearly 150 points to slip below the psychological level of 18000?

Before I attempt to answer that question, a little digression.

Many Indian working/earning men have different types of addictions. Some are addicted to tobacco. Some like to go to the races. Others like to hit the bottle. All such addictions cost money. And that money comes off from the top - i.e. before the monthly expenses are incurred.

In other words, to feed the addiction, needed monthly expenses have to be curtailed. Which doesn't make sense to any one - except the addicted person. Month in and month out, he blows money up in smoke (or in torn race tickets, or in drunken stupors), while bills remain unpaid. And then, money has to be borrowed to pay the bills - making a bad situation worse.

The RBI is facing a similar predicament. Time and again, they have raised the repo and reverse repo rates in a graduated bid to curtail inflation without hampering growth. Without much success. In fact, inflation rate has started climbing again. Why? 

The global downturn followed by the massive money printing (better known as Quantitative Easing - Part 1 & 2) 'exported' inflation to the developing countries like India, by buying up stocks in better performing markets. The Indian government has continued with wasteful expenditure - better known as 'subsidies' - which inevitably doesn't benefit ordinary citizens. 
 
Vote bank politics ensured that required financial reforms and tough fiscal policies were avoided (or at best, not pushed through). Prices of diesel and kerosene have not been increased with the excuse that inflation will climb even higher. Nor have the punitive taxes on petroleum products been reduced, which could have partly mitigated the price hike.

Lot  of sound bytes have been issued about curbing black money generation and bringing perpetrators to book. The fact of the matter is that the few arrests in the various scams have only come about due to prodding by the Supreme Court. The government departments and the ruling party remain the biggest sources of black money generation. 

No concrete improvements will happen in transparency and governance till the elected leaders reform themselves. All the talk about identifying account holders in Swiss banks has led to some of the black money getting re-routed through 'hawala' channels back into the country - further stoking the fires of inflation - and into real estate deals. Probably the reason why debt-burdened real estate companies are refusing to lower the prices of apartments and buildings.

And food inflation? That can be eliminated in one simple step - by allowing FDI in food retailing. All the apparent concern about 'kirana' stores going out of business is nothing but crocodile tears. There are too many middlemen with close ties to the one in Power (pun intended). The humongous wastage will be eliminated through modern refrigerated storage and transportation facilities. Removal of middlemen will be a win-win for farmers and consumers.

Sorry about that long rant. The point is, without appropriate fiscal and policy measures to support the RBI's monetary tightening, inflation is not going to come down any time soon. That is what came out of the RBI's statement today. Which means more tightening and further increase in repo and reverse repo rates in future, while the governments 'addiction' remains uncured.

That is why the Sensex dropped. 

RBI raises interest rates – markets crash; what should investors do?

Regular readers of this blog should not have been too surprised by today’s selling, which followed the RBI announcement raising the repo and reverse repo rates by 50 bps (0.5%) each. In last Saturday’s analysis of the Nifty chart, I had mentioned the possibility:

‘The markets have already discounted a likely 25 bps interest rate hike by the RBI next week. If the actual hike is 50 bps, there can be more selling.’

The RBI governor had adopted a graduated raising of interest rates so far, taking baby steps of 25 bps on the past few occasions. Market players had expected a similar hike this time around, but were taken aback by the aggressive stance of the RBI. So, they decided to head towards the ‘Exit’ doors.

What signal is the RBI trying to convey? Inflation has now become a bigger concern than growth. It needs to be contained, even if growth slows down in the near term. Is that the right thing to do? What happens over the next few months will provide the answer to that question. Interest rate hikes take some time to percolate through the financial system.

The fact is, the earlier rate hikes of 25 bps at a time - in an effort to balance inflation and growth - has not really worked. Inflation continues to remain high, though it has reduced from double digits to single digit. The unrest in the Middle East caused a spike in oil prices that made the inflation situation even worse.

Thanks to the elections in a few states, petrol prices have not been raised. But they surely will be, once elections are over. Diesel, kerosene and cooking gas subsidies are huge burdens being borne by the oil marketing companies. At some point, diesel prices will need to be de-controlled. That will further stoke inflation.

The RBI governor decided to bite the bullet and tackle inflation with a heavier hand now. Higher interest rates will hinder the already slowing credit off-take and capex plans of India Inc. GDP growth in FY12 is expected in the 7.5% – 8% range. Not bad, but lower than earlier forecasts. Profit margins of India Inc. will reduce. That is why the sell-off happened today.

What should small investors do? Some times the best thing to do is to do nothing (and enjoy the extra 0.5% interest in your savings bank account that RBI doled out). Wait for the dust to settle, and the selling to subside. Then pick up some of the better stocks that may have been beaten up badly, and whose valuations start to look attractive.

Related Post

The Interest Rate hike was expected – why did the market fall?

The implication of high oil price for investors – a guest post

With oil prices ruling above $100 per barrel, India’s trade deficit is widening and inflation remains a major concern. In this month’s guest post, Nishit looks at the implication of high oil prices for investors, and suggests how we can benefit from this adversity.

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From a low of about $33, Crude Oil has now spiralled up to a high of almost $110 a barrel. Crude Oil is the lubricant which runs the world, so let us investigate why the rise in price and what are its implications for India.

Most of the crude oil deposits lie in the Middle East. Middle East has been racked by turmoil and unrest. Supply of oil has been threatened in Libya and other parts like Saudi Arabia. The price rise has been mainly on the back of supply concerns.

India imports 70% of its oil, and if the price rises it implies that it would need to spend more dollars to buy the fuel. A country earns dollars by exports, inward remittances by Indians settled abroad and also foreign investments into India.

We spend the dollars on imports. The difference between exports and imports is known as Current Account Deficit. As we import more than we export, we are always in trade deficit.

If Oil is pricey, the deficit widens, and India’s credit worthiness declines making it less attractive for foreign investors. Petrol price rise gets passed on to the consumer, thereby leaving him with less income to spend.

Subsidy on Diesel of almost Rs 18 to a litre weakens government finances leaving it with less money to spend on infrastructure and developmental activities.

In 2008, crude oil price rose and peaked at around $145 per barrel. All the time, as oil price was rising the equity markets did not react too much to the price rise. A month after the prices peaked, the markets tanked. This was aided also by the Lehman Brothers meltdown.

Now how do we play this as small investors?

We have oil producers like ONGC and Cairn. Cairn is a major beneficiary but now caught up in legal tangle over its acquisition by Vedanta, and ONGC has to bear the subsidy burden.

The legal tangle has no effect on its daily operations and hence I would still prefer Cairn to ONGC. Portfolio allocation could be these two companies and Gold. Average gold price per ounce is 15 times a barrel of oil. This implies fair price for Gold now is $1650 per ounce.

This also means avoid the Auto sector, Banks and anything which is linked to rising Interest Rates. Rates will keep rising as government battles inflation and also seeks to raise more money to pay for oil.

Don’t like the petrochemicals sector? Long Gold and short Banks could be an interesting option.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)

Related Post

Cairn India: an oil story worth betting on – a guest post

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 much longer will the Sensex trade within a range?

That may be the question on the mind of many investors, as the Sensex has been trading between 17300 and 18700 for the past 5 weeks. The short answer is: I have no idea. It could be six weeks or six months. Buyers and sellers seem evenly matched. The post-budget rally appears to have come to an end.

What could be the triggers for the Sensex to move up?

1. The RBI may not increase interest rates on Mar 17. Since inflation remains a concern, another 25 basis points rate hike is being expected by market players. Ms K Morparia of JP Morgan said in a recent TV interview that she won’t be surprised by three more rate hikes of 25 basis points each. Not increasing the interest rate will be taken as a positive by the market.

2. Q4 results will hit the market in another 5 weeks or so. With higher commodity prices and higher interest rates, profitability of India Inc. is widely expected to take a hit. If results are flat, even if not better on a QoQ basis, markets may interpret that as a positive.

3. India is still dependent on good monsoons. Agricultural production gets a boost. That helps the rural economy to grow, and has a cascading effect on the economy as a whole. Signs of a good monsoon may shake the market out of its current gloomy sentiment.

What could be the triggers for the Sensex to go down?

1. Despite several rounds of interest rate hikes by the RBI, inflation continues be in double digits. Government spokespersons have run out of excuses. More rate hikes could bring the growth momentum to a screeching halt.

2. The unrest in North Africa and the Middle East has sent oil prices shooting up into three figures. Economic growth and high oil prices are a disastrous combination for stock markets. If oil prices remain high, India’s fiscal deficit and inflation may spin beyond control. As it is, artificially depressed kerosene and diesel prices is causing havoc to the finances of the oil companies. The real inflation rate is much higher than the published figure.

3. The FIIs have pulled out about $2 Billion from the Indian markets in 2011. This amount is less than 10% of what they invested in 2010. Still the Sensex lost 18% from its Nov ‘10 peak. The relative valuations of the US and Europe markets are cheaper. If the FIIs continue with their selling and pull out another $2 Billion, the Sensex could test its May ‘10 low of 16000.

Looks like the sideways consolidation in the Sensex may continue for a while longer. As I have mentioned several times before, investors should not get too bogged down by Sensex movements. When the market is unexciting and boring, it may be a good time to take a vacation and catch up on your reading. If you have already read books by Graham, Lynch, Fisher, Pring – read them again. You will understand many things that you missed when you read those authors for the first time.

Why is the stock market so excited about an unexciting budget?

These are the irreverent views of a non-economist. Take them with a pinch of salt.

It isn’t bad, so it must be good

There was a lot of uncertainty surrounding the budget this year. Rising inflation was not contained even after several interest rate hikes by the RBI. Higher interest rates were beginning to slow down Indian Inc’s growth momentum. Some tough tax measures were expected from the Finance Minister (FM). None came. The markets heaved a collective sigh of relief.

Shorts got trapped

The four months long correction in the stock markets had turned sentiments negative. All attempts at pullback rallies were getting sold into. The FIIs were selling heavily and redeploying in their home markets. Several experienced players were shorting the market. The unexpected surge in the indices on Budget Day was mainly due to short covering.

Auto sector gets an indirect boost 

A 2% excise duty cut was offered to auto makers a couple of years back as part of the economic stimulus. A roll back was discounted by the market. The FM left the excise duty unchanged. Feb ‘11 auto sales numbers have shown decent growth. Auto stocks soared on this twin good news.

Smart move from ITC

An increase in excise duty for cigarettes and other tobacco-related products was widely expected. In anticipation, ITC had increased the prices of some of its most popular brands prior to the budget. No such increase was announced by the FM. Don’t expect your pack of smokes to get cheaper. ITC’s bottom line will be a direct beneficiary.

Not so great for Mukesh Ambani

By transferring his shareholding in Reliance to a clutch of Limited Liability Partnership (LLP) companies, Mukesh Ambani ‘legally’ avoided paying income and other taxes (such as dividend distribution tax). LLPs have been brought under the purview of 18.5% MAT. Bad luck for big brother – he has to now pay taxes like a mere mortal! If only he had known earlier, he may not have built the ostentatious eyesore he calls home.

Reduced surcharge on corporate taxes

This would reduce cash outflows, and is a definite positive. Hopefully, the extra cash will get channeled into expansion activities and help to increase GDP growth. Investors may get rewarded with higher dividends.

Tax benefits for senior citizens

By reducing the qualifying age for a senior citizen from 65 to 60, several lakh tax payers will be able to avail higher tax exemptions. Some of the extra tax savings are likely to find their way into MFs and equity.

Does all this justify a 600 point rise in the Sensex today? Is the correction over? Should investors start buying again? Answers to these questions will become clearer over the next few days – now that the uncertainty about budget proposals are behind us.

Don’t let relief cloud reality. There has been little change in the global or local situations. Uprisings continue in the Middle East. Higher oil prices will further stoke the fire of inflation. Get set for another interest rate hike. FIIs were net sellers on Budget Day. The Sensex and Nifty are near strong resistance zones.

Stick to your asset allocation, and don’t get swayed by short-term index moves.