Archive for April, 2007

ULIPs lower management fees must be matched by performance

9 comments Written on April 30th, 2007 by
Categories: Insurance, ULIP
Agents are selling ULIPs (Unit Linked Insurance Plans) saying that they have WAY lower management fees and they will therefore, in the long run generate better returns as compared to mutual funds. HDFC Insurance for instance has a 0.8% management fees versus typically 2% fees by regular mutual funds. Now over the long run, says HDFC Insurance, the difference in management fee and lower entry loads will make a huge difference and lead you to greater returns.

They typically show you a spreadsheet showing a comparative analysis, taking 2.5% as annual management fees for a mutual fund (the max. a fund can charge) + 2.25% entry load for your yearly investment. On the ULIP end, they reduce all the annual charges - 0.8% management fee, some monthly fees and some commissions. Then they assume both funds will grow at the same rate - say 10% - and demonstrate how, at the end of 20 years, ULIPs will yield a better return.

They may be right, but only if returns from mutual funds and ULIPs are similar. Let's run a check over the last three years, for the ULIPs that really have existed that long.

A pure NAV comparison: It is obvious here that ULIPs have severely underperformed mutual funds. For a three year period, the best performing ULIP returned 159%, and the best performing ELSS fund returned 252%. In fact, HDFC's own tax saving mutual fund returned 75% more (over three years) than its insurance growth fund!

I have not considered ALL mutual funds - only tax saving funds. The results are worse for ULIPs if you consider strong growth funds like Reliance Growth, SBI Magnum Global etc. I have also disregarded any shorter term than three years - it doesn't make too much sense to compare in those terms.

If ULIPs are to really go away from paper spreadsheets and beat mutual funds as an investment product, they must pull up their socks and perform. Their claims of lower management fees only makes financial sense if they yield as much or better returns.

Posted in Insurance, ULIP

What is an ESOP?

14 comments Written on April 30th, 2007 by
Categories: Options
Employee Stock Option Plans (ESOPs) are commonly heard today, especially in IT companies. So what's this all about?

Okay, let's start with history. Companies would earlier hire people and pay salaries and bonuses. That's ok. But some companies couldn't afford high salaries, so they hoped to provide their employees with shares of the company, in lieu of salary. The idea being, as the company did well, the stock price would go up, and the shares would yield rich returns, perhaps much more than the salary they forego.

But if you just gave an employee shares, he may resign the next day and gain from future stock price increases but give the company no value. That's not good.

So companies make the shares "options" - this is a derivative product. The idea being, if you work for the company for this long, we give you so many shares. This is called the "vesting period". Companies have vesting periods of 2 years or so, and after that every year, further shares are offered.

But do you get the shares free? No. Earlier companies used to give shares at very low prices, but that affects other investors (I will explain later). So SEBI has regulation on how the pricing of stock options can be made (typically, average price over the last six months).

So, a stock option is the right to buy shares at a certain price (called the 'exercise price'), and ESOPs are rights to buy shares at a certain price after the vesting period, provided you still stay employed in the company.

When your shares vest, do you automatically get them? Again no. You have to pay some money to get the shares - this is called "exercising the option". When you exercise, you pay the option's exercise price, and get the shares in your name. Some people don't want to pay up, so the options remain vested, but unexercised.

Let me show this with an example. Let's say Shenoy Solutions, an IT company, has 100,000 shares currently priced at Rs. 10. The company offers an employee, Girish, options for 1000 shares at Rs. 10, after two years.

After two years, the price of the share is Rs. 40, and Girish exercises the option - he pays Rs. 10,000 and the company issues a further 1000 shares, taking the total number of shares to 101,000. Girish now owns 1,000 shares.

How does this affect you, if you are a normal shareholder? It dilutes your equity. The EPS is a guiding factor to the value of a company - if the number of shares increase, the EPS will go down. You may think it's inconsequential - but look at recent times - Infosys' EPS will be hit by 10% (!!) in 2007-08 because of exercised ESOPs.

One of the recent problems with ESOPs is the change in legislation - companies are required to pay FBT on ESOPs - on the difference between the market value and the offered value. This is too much to handle, so nearly all companies asked employees to exercise their vested ESOPs. So nearly all tech companies will have an EPS hit this year with larger number of shares now available.

ESOPs are good tools for retention and compensation. But there is a cost to the option - if you tried to sell the same option in the marketplace, people would be willing to pay a high premium. This is money that the company does not recover from the employee, so technically, it's a cost to the company - that must be reflected in the balance sheet. But India has no such law, so the cost goes unreflected - and I must say I agree that the profits will then appear inflated to that extent.

ESOPs are interesting - for you as a shareholder, to assess the impact on your companies' EPS, and as an employee for potential future gains.

Posted in Options

IPO investing for retail investors

3 comments Written on April 29th, 2007 by
Categories: IPO
Bullish Indian offers 8 tips to retail IPO investors. The article says IPO investing is a low risk way of making money.
The truth is, investing in IPO is an easy, low-risk way to make an average of 2-3% in 20 days. A 2 -3% return can seem very low on a nominal basis, but when you calculate the annualised return it becomes very attractive. You can make an annualised return of about 30%, on an average, easily by investing in quality IPO’s by following the guidelines mentioned below.

His approach is quite interesting, since he prefers looking at institutional investments and bases his IPO investment on how much they are oversubscribed. If institutions bid for over 5 times their quota, he says buy. And if the whole IPO is more than 50 times oversubscribed, he says ditch the IPO, for getting allotment will be difficult.

If his theory was universally adopted, it would be a problem because institutions need not pay a single paisa before putting their bids. Retail investors have to pay all money up front. (An exception to this was the RPL IPO where institutions paid up 10% of all bids) Meaning, if an institution wanted to manipulate the stock price it could easily overbid and withdraw in the last minute. (And by the way, nearly all stock manipulation is institutional)

Also he mentions a potentially unethical concept - of paying by cheque and then doing a stop payment on the cheque if the IPO subscription statistics released later in the day don't meet his conditions. Even if you argue it is ethical, if this kind of thing becomes common, IPOs will mandatorily require Demand Drafts or direct transfers. It costs money to process a stopped-payment cheque, and eventually it will only hurt us investors if they bring in such rules.

Now I don't know how good his strategy will be, but Kaushik at Galatime conducted a study in 2005, and found that the upside was 83% vs. a downside of 12%. That's quite a reasonable risk to take.

But it may not make financial sense if you want to do this consistently. I noted earlier that the cost of IPO investing can be quite high, and yields quite low. But if you choose the right kind of IPO (Opto Circuits is one example) your risk is extremely low and the yield excellent - can be 2-10% a month!

Remember also that IPOs flourish in a bull market. In declines, most companies don't even go for IPOs. DLF's IPO has been delayed over a year after all barriers were cleared - yet, every time it tries to announce an IPO something bad happens to the market and they go back underground. In such a situation, you may make 5% a month for three-six months and almost nothing in the rest of the year.

Finally of course remember that refunds can take inordinate amounts of time. Some readers have noted that they never got refunds from the Mindtree IPO even after two months, which completely messes up any positive effect of the IPO.

All in all, the strategy mentioned in the article is noteworthy and provides an excellent starting point for retail IPO investors. One question you may have is:

How to get oversubscription statistics? Visit the Current Issues at NSE and click on the IPO you want to invest. That will contain day-end statistics, and for real time stats, you can click the "NSE-BSE demand graph" link to see overall subscription.

Posted in IPO

Market advise, pinch of salt

3 comments Written on April 28th, 2007 by
Categories: Commentary
Toughiee has a very interesting post on the Futility of Market Forecasters. He has taken to task Gautam Shah of JMMS, who forecast a major fall when the Sensex was at 12,300 recently, and on March 28,2007, he predicted that tech stocks would lose 12-15% in three weeks.

The rest is history. Not only was 12,300 the temporary low of the market over the last two months, tech stocks have rallied comprehensively over the last month! If this particular analyst had put money where his mouth was, he would be a much poorer analyst.

I've posted on this earlier, and also how media twists the headlines so much that they convey the wrong impression. But what we need is really good data like Toughiee has compiled, and perhaps Indian versions of US sites like CXOAdvisory which takes all public predictions by "market gurus" and checks them against what really happens.

I've been at fault too. I asked people to get out of the market on April 21, 2006. True, I may sound like an angel now because the markets crashed on May 11; but I can't always be right. Predicting the market in the short term is downright stupid; and even in individual stocks, my predictions haven't all worked.

What the market teaches you is humility. That you can take nothing for granted, and that value is a figment of your imagination. Predictions, therefore are ticking time bombs. Like someone said:

Advise is the only commodity on the market where supply always exceeds demand.

Posted in Commentary

I am a stupid investor

13 comments Written on April 20th, 2007 by
Categories: Futures, Options, Stocks
I mentioned in my last post that I bought a Put option on Tata Steel. Now notice how much the 510 put option has fallen today. From Rs. 12 at yesterdays close to Rs. 2.4 closing today. That's a loss of 80%!

(This option is the right to sell Tata Steel at 510. I bought it when the stock was doing 505 so it was "in-the-money" then, not considering my premium. It closed at 533 today)

And the figures are grim. You can't buy just ONE share - you have to trade in lots of 675 (the number differs for each stock). Now, this is a loss of Rs. 9.6 per share, so for one lot you would have lost Rs. 6480 in one day!

Okay, I've lost that much. And I know this: I am a stupid investor, making the most common errors. I will try to learn of course, and tell you what I learnt, so you don't make the same mistakes.

Ddue to reasons of having actual work, I missed opportunities to sell the put and lower my loss. Unfortunately, I can't blame anything else - this is the price I pay to learn.

Was this my first exposure to options? Not to index options - which I buy and sell Nifty options fairly regularly since my opening of a Reliance Money account which has extremely low brokerage. But it was my first exposure to single stock options.

The options are extremely volatile. In general options can move around 10-50% in a day, and usually do. I should have been more careful- and watched the put move around a day or two before I placed my order.

Second, this was an aberration of sorts. Tata Steel is up 5% in the day. This kind of movement does not happen regularly - in fact it hasn't happened like this in the past few years! So I should not let a one time movement of this sort affect my broader judgement.

I also forgot to consider that the option expires on 26 April,next Thursday. At that close a point, buying out-of-the-money puts needs more research. My research may be sound, but it may not impact the market in one week! Perhaps I should have waited.

And finally, I have learnt that trading options is not something that you do without serious time devoted. Given the high volatility, you should track the option closely and take out your losses earlier (and also, book gains faster). This does not mean close stops, it just means that the time between buying and selling should be small. Options decay over time.

So, lessons learnt:

1) Your logic may be sound fundamentally, but it may not pan out for options, which have a shorter duration of existance. Nothing in Tata Steel will change till next Thursday so my entire analysis has no relevance to this month's option. Tata Steel is still a sell, but not on this month.

2) I should have sold the future instead. Yes, that needs me to keep more as premium, but that also means I can roll it over to the next month in case the share price doesn't move down. (You can't roll over options you buy)

3) Don't ever trade options unless you have the time to track them.

4) Options are very very volatile. Setting close stop losses in options is stupid - you will get stopped out with the volatility. Setting far stops is much higher risk, so you should choose a lower premium option. If I had chosen the 480 put instead of the 510 put I would have lost just Rs. 1,500.

5) Don't blindly buy an option just because it looks good. Watch the way an option moves, at least for a couple of days, before you take a decision. At least if you are investing in single stock options for the first time!

6) Tata Steel's rise today was not something that happens everyday. So this shouldn't discourage me (or you) from understanding option trading.

Futures and options are very interesting. Typically futures involve between 25,000 to 50,000 of margin per "lot" and it's not money gone down the drain, it's money that's with your broker who will return it when you square-off or exercise. Selling options (or "writing" them) involves the same kind of margins, but buying options just involves paying a premium (which you don't get back).

Nifty options involve small premiums - a lot of 50 Nifty can cost you just Rs. 1500. That's probably a better thing to use to learn.

But a series of small profits can be wiped out by one big loss, as I learnt. it's time to use the golden rules of trading: Risk, Allocation and Money Management. I got them all wrong this time. But I'm learning.

Posted in Futures, Options, Stocks

Tata Steel and the Corus buyout structure: Not Worth It

11 comments Written on April 19th, 2007 by
Categories: Stocks
Tata Steel (Tisco) revealed how it will fund the Corus Acquisition ($12.9 billion, or 52,000 crores). Out of this, Tata Steel will provide $4.1 billion (Rs. 17,750 cr).

Equity:
1) Promoters (Tata Sons) have, on April 18, converted preferential allocation of 2.85 crore warrants to ordinary shares at Rs 484.2 a share. That's a net amount of Rs. 1380 cr.

2) Rights issue at 1:5 (five for every one share held) at Rs. 300 per share. This is a 40% discount to current prices of Rs. 500 per share. They'll raise 3,660 cr. this way, giving out 12.2 crore shares.

3) Preference shares of 1:7 (1 shares for every 7 you own) for Rs. 4350 cr. at 2% interest, convertible at a rate between Rs. 500 and 600 after two years. Let's assume the price to be Rs. 550. That's an additional 7.91 cr. shares.

4) A foreign issue of equity for about $500 million (Rs. 2100 cr.) Let's also assume a price of Rs. 550, and this yields us another 3.82 crore shares issued for this.

5) A "quasi-equity" issue (meaning: We are going to dilute, we just wont tell you how much right now) by Tata Singapore, for $1.25 billion. Let's assume Rs. 550 per share for this, gives us an equity dilution of 9.77 cr. shares.

Internal Accruals:
1) Own cash of Rs. 3000 cr. ($700 million)

Debt:
1) External Commercial Borrowing of $500 million (Rs. 2170 cr)
2) UK Debt, already taken and with no recourse to Tata Steel: $6.14 billion, about Rs. 26,400 cr.
3) Tata Singapore has taken on debt of $1.41 billion (Rs. 6063 cr)

Now Tata says the cost of servicing this debt is 4.3%. Let's apply that to all the debt they've taken, which totals 34,635 cr. The cost of servicing this debt is 1489 cr.

Let's now see how much Tata Steel earns today, and how much it stands to earn. The last four Quarter earnings are Rs. 3901 cr. This translates to a current EPS of Rs. 67.21 per share, at a current share capital of 58.05 cr. shares. (This is a P/E of 7.5)

Corus, from their last results, has shown a 269 million pound profit for the first three quarters of 2006 (fourth quarter results are not available). But if we annualised it and used a pound rate of Rs. 84, we get a Net Profit of Rs. 3013 crores for Corus. (Note: this is LESSER than Tata's annual profits)

Now let's add this up and deduct the cost of servicing the extra debt, and we get a consolidated net profit of Rs. 5426 cr. for the merged entity. With all this equity changes, the total equity will increase to 94.6 cr. shares. For the additional share dilution, the real EPS will then become Rs. 58 per share.

At the current share price, the P/E will then be Rs. 8.81, a 17% premium to today's price. For a commodity business this is quite high, and other steel businesses are available for lower than that - a P/E of 6 to 7 is probably more sustainable. I would think that the price of this share should be between Rs. 430 and Rs. 440 for it to be a good buy.

Unfortunately, this is not how the company will show it. In Indian law you are allowed to "ignore" future dilutions, even if the money has come in today. Meaning, they will not show the increased capital (through the preference shares or the rights issue) until after the conversion to shares; but that is terribly unfair, because the money is already paid! So they will show you lesser number of shares than the above, and therefore a higher EPS.

This is unfortunate because it's legal. But you should read between the lines and find the true EPS rather than going by what the company reports.

There are other factors that will affect the merger. Consolidation can take two years when companies of this size merge, and the positive effects of that consolidation will be visible three years away - in 2010. Till then the profits will be subdued, though the reported EPS will be higher.

Further, to control inflation, the Indian government wants steel companies to keep prices lower. That is not a good sign.

But the positive is that in the long term, Tata's lower costs will help the merged company make much higher profits. That is a long time away - 2010 I would expect - and steel, being a cyclical, may have a downturn in the meantime. Any steel price depression will severely affect the real EPS.

My recommendation is: Don't buy at this price. If you already own shares sell them - a better price would be far below this, around Rs. 430 to Rs. 440 per share. And I think this share will reach there in the next three quarters - that is, by October 2007. That will be a better time to evaluate purchasing this stock.

My analysis:

Notes:
1) From Business Standard:

At the current price of Rs 510 a share, the effective cost per share—if one subscribes to the rights issue at Rs 300 a share—is Rs 475. At Rs 475, the stock trades at a multiple of 6 times estimated FY08 earnings and around 5.5 times FY09 earnings. That is not cheap for a commodity play over a two-year horizon.

2) Some of the above is unfair. Tata Sons, in 2006, paid Rs. 51.6 per share for 2.85 cr. warrants, convertible they said at Rs. 516 per share "or as per SEBI standards". They also paid Rs. 516 for about 2.7 cr. shares. Now when the price is around 500, they converted the warrants at Rs. 474.2 per share! At a time when Tata Steel really needs the money, Tata Sons is paying so much lower than market price. But you could say that they did pay Rs. 516 per share in August last year, so it's only right that they get a lower price now. Anyways that's a lost story.

3) The Rights issue is at 1 more share for every five shares you own. So if you buy five shares today at Rs. 500, you could buy 1 more share at Rs. 300, giving you a total of 6 shares, for Rs. 2800. This is equivalent to Rs. 467 per share, to which the share will come down, obviously.

That means a) buying now or owning shares now and not subscribing to the rights issues is downright dumb - but many investors who have no time to handle a rights issue, will do exactly that, and in the process lose 5% of their share value. Rule No. 1: If you own Tata Steel shares, and have no time to handle the "rights issue" paperwork, or can't pay Rs. 300 for every five shares you own, SELL all your shares immediately.

4) I have a short position in this stock. I want to put my money where my mouth is, so I've bought a put option on this stock to see if I can actually make profits from my analysis.

Posted in Stocks

Stock Update: Balaji Telefilms

1 Comment » Written on April 17th, 2007 by
Categories: Stocks
I recommended Balaji Telefilms on Aug 26, 2006 at Rs. 118, and reviewed it to a target of Rs. 175 within a year.

The price is now Rs. 161 and the company gave a dividend of Rs. 3.5 per share, bringing your net return at Rs. 164.5 per share. The current return is around 40% in 8 months.

The stock looks good, and earnings data should be out very soon. They haven't revealed dates yet, but I'll keep you posted. Meanwhile, I would recommend that at 50% gains (depending on when you bought the share, it went down to Rs. 110 in the middle) please book profits on 1/4th your holding.

But do your research - the stock's moving up fast, and it may be better to go with the momentum. That's your call.

Note: I've just started to sell, will sell upto 1/4th my holding by price of 175.

Posted in Stocks

Cold shoulder to "hot tips"

15 comments Written on April 16th, 2007 by
Categories: Commentary
SEBI is looking to tighten regulation for investment advisers who offer "hot tips" on the Internet, SMS and other media. For this, it is asking for help from the SEC, the SEBI equivalent of the US.

SEC has set up legislation for advisers, who are required to provide a Form ADV to the regulator (which is searchable) and required detailed disclosure of fees charged, other income received, any pending legislation etc. All advisers "who manage assets more than $25 million" must be registered federally, and others need state level registration.

From SEBI it seems:

Amid the sharp rally in the Indian stocks over the past few years, the public interest has grown manifold in the market and so has been the number of advisers -- who keep inundating investors with "hot tips" on which stocks to buy or sell through TV channels, newsletters, magazines, newspapers, websites and some innovative media like SMS and phone calls.

Damodaran has expressed his discomfort on many occasions over the the growing number of self-appointed advisers, while there also have been certain cases when the regulator has fined individuals and entities for dishing out tips on market activities without proper disclosures.

The matter has become a nuisance after cases like the Anirudh Sethi episode, where SEBI issued an order banning him from giving market tips. His "hot tips" in exchange for money, says SEBI, involves a contract that effectively manages portfolios, and therefore is governed by SEBIs portfolio manager rules. Of course, that would incite protests, as the registration procedure for a portfolio manager is a fee of Rs. 10 lakhs upfront, Rs. 1 lakh a year and requirements on minimum net worth etc., which is obviously going to restrict investment advise only to the ultra-rich. Not desirable.

So SEBI has to regulate the advisory space, yet keep it regulated so people don't try to offer ridiculously high guarantees or have no penalties for misinformation. And in the process, not stifle the freedom of press - which means they can't stop anyone writing in the media. How they do this will be interesting.

Note: SEBI has asked for comments from the public on how to handle this.

Posted in Commentary

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