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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Easy Money – not easy

Posted by Muthu on July 31, 2012

In our apartment every one knows about my profession but no one is my client:-)  But some do drop in for occasionally for getting my views. 

Last week a lady in our apartment came to my house to discuss about a scheme offered to her by a leading financial services company. Three people from that company had visited her couple of times, made excellent presentations and asked her to sign up as their client. The agreement was thick and dozens of her signatures was required. They have orally promised her for an investment of Rs.1 lakh, she would get around Rs.1500/- a day from commodity trading.

I asked her to send me that RM. He may be earning around 50K a month. All he need to do was invest Rs.2 lakh to earn the same income, if what he say his true. Why he should go door to door when he can get his salary so easily? The lady got the message and the RM never turned up.

Long ago, when I was employed, a colleague brought his relative who is a chartered accountant, who claimed to have found fool proof strategy to make profits in derivatives. He came and explained how I can get 5% returns consistently every month. If you have Rs.10 lakh, a 5% return every month means, your corpus would be Rs.1 crore+ in 5 years and would be Rs.11 crore in 10 years. I asked him how much he can borrow. He told me Rs.30 lakhs. I asked him if he has found a way to make his corpus Rs.30 crore+ in 10 years; why he need me as a client. I told him that if I know such a way, I would never share it with any one:-) 

He was not amused by my response and was unhappy when I did not take his calls further. Due to relationship, my colleague and his family invested their money and lost every penny. This CA belatedly realized what he did was wrong, quit trading and started going to job. The sad part is that he passed away with in a year due to cancer.

Some time ago, I received an invite from a company to be a partner in ‘Quant trading’. It said that investor can make above 5% every month and I would be getting my fat commission too. When a representative from firm repeatedly called me, I told him that with a capital of Rs.1 crore, their company can make Rs.100 crore in 10 years and over a period even appear in Forbes list of billionaires. In their presentation they have mentioned some prominent advisory firms as their clients. If it is true, I can only pity their clients.

From Amway to Divine Noni, all kind of people meet me to say that how I can leverage my relationship with clients and make good money.

All these people say making money is easy, both for me and my clients. If making money is that easy, so many would not work hard for longer hours to earn a living.

I invest in equity both through mutual funds and direct stocks. Direct stock pickers whom I’ve met feel that it is very easy to make money in markets.

Stock market is one of the least understood phenomenons in our country. Either people think this as a gamblers den and shun it or they feel this is the place to make easy and quick money.

The number of people investing directly in stock is very less in India. When I speak to some of the direct investors, I’m shocked at their level of understanding and I pray to God to forgive them as they do not know what they are doing:-)

One person has a portfolio of 25 stocks. He did not even know what business those companies are in too. He had no clue of the financials, valuations of these companies too. He bought because his broker said that these stocks would rapidly multiply his money. Many companies in his portfolio are speculative counters having little fundamentals. I find this to be a good representative sample for many retail investors.

One can never make money this way in the stocks and that’s why many don’t do.

None (except rare few) of the retail investors I’ve met was unable to answer the basic question as to what a share price at a given time represent. When a stock is selling at Rs.100 and if the earning per share (EPS) of the company is Rs.10; it means the market is willing to pay 10 times the earnings for a company.

To illustrate, SBI share price was Rs.2031 yesterday. The EPS is Rs.174. This means the market is willing to pay roughly 12 times the earnings as the price. On the same day the share price of Asian Paints was Rs.3574. The EPS is Rs.102. This implies that the market is willing to pay 35 times the earnings as the current price.

The market capitalization (total number of shares multiplied by current price) of SBI is Rs.1.36 lakh crore. Theoretically speaking, SBI is all yours if you have Rs.1.36 lakh crore to pay and the government is willing to sell the same to you:-) Another example easy for you to relate is Jubilant Foodworks. You may say that you do not know any thing about this company. This is the Indian Franchisee of Dominos Pizza and they are the one who deliver the Pizza you like. The market capitalization of the company is around Rs.7400 crores. With EPS of Rs.18, the market is willing to pay 64 times of the earnings.

 You’ve seen three companies where the market is willing to pay multiple of 12, 35 and 64 respectively. So the multiple given by market determines the price. If market decides to give SBI the same multiple as Jubilant Foodworks, the price of the SBI would be around Rs.15,000 per share!!. The earning is made by the company but who decided the multiple? Simply the market, the people like you and me. Multiple depends on market condition, sector growth, company fundamentals, future prospects and last but definitely not least the market fad. In the IT mania of late nineties, many Indian IT companies got sold at 300 times, 500 times earnings etc. 500 times earning implies, assuming the earning does not go up; you are paying next 500 years of earnings to buy a share. Sound crazy? It keeps happening all the time.

As a broad thumb rule, the company should grow at the same level of multiple to justify the price. This means Jubilant Foodworks should grow 65% a year to justify the current price. This kind of growth rate is not easy to achieve. Pizzas, cookers, suitcases and underwears (Page industries, which is the Indian franchisee of Jockey) are the current market fad:-) 

The best thing would be to not to chase the current fads and also not short sell them. Short selling means borrowing a stock and selling them in anticipation of the price to go down so that you can buy again at a lower price and return the stock, pocketing a nice profit in the process. Short selling is sophisticated and requires very deep pockets to wait patiently. 

I want to share with you what I heard though it is not the first hand information. In last bull market, one ugly duckling was selling at hundreds of multiples. People who knew about it stayed away from them. Some were riding on the momentum by simply buying and selling the share and making some profits. One retired person in suburban Chennai, who rightly guessed that the share is at unsustainable heights, went short on the same. But the price continued to go up and to face the margin requirement he has to liquidate his entire retirement corpus. Unable to withstand the total loss of his wealth, worried as to how he will tell this to his wife and daughter, even more worried as to how he is going to get his daughter married, he committed suicide.

Talking about shorting, do you know my success rate in short selling is 100%? Let me explain. In mid nineties when I was working with a stock broking firm, I used to watch lot of companies and read financial newspapers at office. There was a person called Pavan Sachdeva running a company by name M.S.Shoes. There used to heavy advertisements by the company in newspapers. Pavan’s photo would be half of the advertisement.

I never like people who promote themselves more than there organization, exception is Wise Wealth Advisors:-) As lot of negative news started flowing about the company, I short sold the share. To my surprise, I made money few times my monthly salary in this one single deal. Immediately my mind started working. If only I can do 3 to 4 deals, why I should work at all? And what if I’m able to make lot such deals so that I can get rich within few years? Why people are foolish enough to work all their life?

Candour has always been my virtue or vice. So I went and told my boss what I thought above. My boss was matured enough to understand my immaturity. He spent good amount of time explaining why people like me should never short, the pitfalls and many examples of people gone broke because of this. He said that short selling can literally kill me. I understood the message and never shorted shares again. That explains my success rate of 100% in short selling.

As a stock picker, one should understand a lot about valuations. Valuations can be arrived partly by ratios and more so  by understanding of business. Benjamin Graham, the father of security analysis has stated one simple valuation ratio for buying, which I found handy many a times. The PE ratio multiplied by price to book value (PBV) should not exceed 22.5. In the example given above for Jubilant food works has got a PBV of 25 and PE of 64. So the Graham multiple is 1600, way above 22.5 recommended by him.

Disclaimer:  I do not have any position in the above companies and it is not a buy or sell recommendation but merely an illustration. The mutual funds our family owns may or may not have position in the above companies.

My stock picking abilities till 2008 was more of luck. No doubt luck is important but the basis of investing cannot be only alone on luck. In the last 4 years, I read, thought and analyzed a lot and now is reasonably confident that I qualify to be an amateur stock picker.

Read atleast last 3 to 5 years of annual reports of company you want to buy. If you do not understand the annual reports, stock picking is not yet for you.

For those of you interested in investing in stocks, you may read the following.

1)     One upon the Wall Street

2)     Beating the Street

3)     Annual letters of Warren Bufett available at http://www.berkshirehathaway.com/

4)     The Dhandho Investor

5)     Fooled by Randomness

Once you finish reading the above, you would know yourself what to read further.

Books can be good pointers but on their own cannot make anyone a great investor. Not every one who knows English can be a Shakesphere. Likewise all those who know or understand about investing cannot become like Warren Buffett. This need not be a deterrent as we may not have any intention to have 100 or 1000 crores but rich enough to have a life style we want.

Please note that I would be glad to discuss about stock picking approach with anyone. I would also learn during the process. But I would never ever give any recommendation on buying or selling. I’m very clear about this.

Someone asked me by discussing about stock picking will I not loose clients?

I and my family still invest in mutual funds; do SIPs in addition to direct investing in stocks.

If a client is confident to be on his own and directly invest in equity, I would encourage him. I do not want to hold any one either through fear or ignorance. They should be with us because of the value they see in us and definitely not due to fear and ignorance.

I would like to ask 2 questions for the direct stock pickers. People who are answering correctly would get a note of appreciation. It is invaluable:-)

1) What  diluted EPS means?

 2) In bank balance sheets, the contingent liability is many a times the net worth and market capitalization of banks? Isn’t this implies when contingent liability arise the bank may go down? What then exactly this means? 

One last line: Investing looks deceptively simple. It is not.

4 Responses to “Easy Money – not easy”

  1. 1. Basic EPS calculation takes into account only the outstanding number of ordinary shares in the denominator (in equation of net profit/no. of shares) whereas for calculating Diluted EPS, the denominator also takes into account the existence of any instrument which can be converted into equity share into future. like Warrants, Options, FCCB etc…
    2. Will need to read up on this. Will get back.

    Your posts are a treat to read, as always.

  2. Hi Muthu,

    Here is an attempt to answer the second question based on my limited understanding after reading few things

    Contingent liability as the name suggests is contingent to some event happening. For examples, it could be the liability arising out of a bank guarantee when the client defaults, or a forex hedging operation going agiainst the bet.

    It’s an off balance sheet item as their is no matching item on asset side on the balance sheet. I checked few Banks for the extent of CL, and here are the results:
    Karur Vysya – contigent liability of 2.9 times of networth
    Indusind – 21 times of networth
    HDFC – 28 times of networth
    City Union Bank – 4 times as per 10-11 AR

    Banks must be taking this liability for generating fee income. so, theoretically if they have to pay for all of this liability which is well over their networth, then they can go down. So, i think Banks might be considering the probability of the default and then pricing such liabilities. But i think this question is something similar to asking an insurance company, what happens if it has to pay back to all it’s policy holder for their respective insured event. Is my understanding correct ?

    Also, i think a more risk prudent bank would not take too much of outsized contigent liabilities in comparison to it’s networth where the only thing it can earn in best case is the fee for taking the liability.

    Thanks for this interesting question, read and learned few things. I am always willing to do some assignment on analysing direct equities. If you please, do let me know if i can be of any help. Will be happy to make any contribution in exchange for a chance to learn from an experienced investor like you.


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