1. Abc of Equity Market

Basic Terminology

Highly educated have problem of Analysis Paralysis, i.e. habbit of collecting lot of data, becomes in-decisive with confusion by lot of data

Two major stock exchanges in India

    • NSE

    • BSE

    • NSE has well known Index called NIFTY

    • BSE has well known Index called SENSEX

SEXSEX

  • basket of 30 stocks, by market capitalization

  • value determined by price of stocks

  • The highest m-cap company is ranked as no 1 in Top 30 list

  • While price of stock of a company changes, its m-cap changes which leads to its rank change in top-30

  • Even the companies change in top-30 or sensex, as the company m-cap changes

  • If a company m-cap\rank change from 30 => 31, the company moves out of index and replaced by company with higher m-cap say which was rank 31 => 30

NIFTY

  • basket of 50 stocks, by market capitalization

Why is SENSEX or NIFTY needed?

    • Misconception: To have a barometer for stock market

    • It is not only relevant for person investing is stocks, but also for others

    • It is actually a barometer for your life, reflection of how well an average indian is doing in life

    • It is reflection of the consumption capacity of the country

    • Companies which do good, would bubble up to be in Sensex or Nifty (so you don't need to worry about picking the top companies)

GDP - Gross Domestic Product

    • Value of all good and services produced (or say consumed) in the country

    • GDP is ~2.5 trillion $ for India

    • Now, let's drive the relevance with the NIFTY

    • The m-cap of top 50 companies in NIFTY is ~1.25 trillion $

    • This reflects NIFTY is 50% of GDP and how NIFTY is barometer for the consumption capacity of the country

    • GDP growth is either by increase in price of sold goods and\or increase in quantity of sold goods, there-by increase in value of sold goods

    • GDP growth by inflation i.e. increase in price of sold goods is not real growth

    • Nominal GDP growth : increase in price of sold goods and increase in quantity of sold goods

    • Real GDP growth : increase in quantity of sold goods only (i.e. removing affect of inflation) : Nominal growth - Inflation

    • In long term, co-relation between GDP & NIFTY growth would be ~1

What to Buy

    • Buy Index - Sensex or Nifty and leave it to grow

    • Problem - What do people engaged in Active stock exploration do - Where is entertainment in it

    • That's correct many people do active stock for entertainment for a kick

How to pick a Stock

    • You don't have to pick a Stock, just pick the index

Investing Vs Speculation

    • Trading in stocks with news around is a speculation not investing

    • Investing is buying(not selling) a asset which has future earning growth potential

Active Vs Passive Income

Active

    • Require effort, from the daily work

    • High returns , 100%, Infinity

    • Not scalable

    • Full fill the needs\expenses

Passive

    • Gives return while you sleep

    • Moderate return

    • Scalable

    • Wealth creation

What makes you rich?

    • Its not the return but the scalability that makes you rich

    • Active return should feed the Passive

    • Passive with time ingredient makes you rich

    • Young age, both active and passive should go together

Risk and Return

    • Bank Deposit: Secure with low returns (~7%)

    • Any asset with higher security will have lower return and vice-versa

Stock Market:

  • Index can't become zero, as some of other company to be part of it

    • Capital risk isn't applicable in long term

    • Risk of volatility

Golden Rules

    • Rule-1: Protect your capital, moderate return with low risk

    • Rule-2: Never forget Rule-1

    • Compounding should continue even with moderate returns

Flaws

    • High risk high return

    • > Risk should not high enough to vanish the capital

FAQ

    • Market Cap or value of a company : No of shares * price of 1 share

    • =rate(38,0, -100, 35000)

    • 38 years, 0 recurring, invested 100 in beginning, 35000 current value

Source of Investment

    • Save from planned expenses by lowering the budget e.g. vacation, car, home etc

    • Use saved money for investment

    • Have to sacrifice something to fund the investment

    • This small saving could turn big in 10-15yrs with power of compounding

Approach for Gains

The simple way for gain is to buy at a low price and sell at a high price.

Now the determination of price as low Vs high is usually done by PE theory (price to earning ratio), i.e. PE of a stock

PE Analysis

How to calculate PE, say a Stock

PE = Price/Earning

Price = price of 1 stock

Earning i.e. EPS (earning per share) = (Quarter Profit * 4)/ No of shares

Suppose a PE of 10, if Rs 10 is invested, end of year earning would be Re 1

PE ratio isn't absolute, its comparative. PE cant tell whether its cheap or costly.

PE is used to compare companies and evaluate which one to buy

Use Case-1:

    • Large Petro company C1 with PE ratio 10, For earning Re 1 invest Rs 10

    • Small Agri company C2 with PE ratio 1, For earning Re 1 invest Re 1

    • Which one to Buy?

    • Now, if its so obvious why is market is so dumb to invest in C1 instead of C2, or why is price of C2 not 10x. Usually its not a case

    • Let's understand why is market giving premium of 10 PE to C1

    • Could be - future credibility (mgmt, product, company won't close) of C1 giving earning is high

    • future credibility of C2 would be lower for market analysis

    • Now, suppose we buy C2 seeing PE and technology changes leading to C2 collapse

    • So, it is difficult to choose a company only based on PE

    • Conclusion: PE only tells what's price you are paying for the investment in a company. PE doesn't tell future visibility of a company

Use-Case-2:

    • Flaw in Use-case-1 is different industry, should be comparing company in same industry

    • Even in same industry it could be same domain e.g. urban focused private bank Vs rural focussed Govt bank are not same, with 2 differences rural and govt

    • Usually companies in very similar domain and future visibility would have similar PE, not like 10 and 1

    • Now lets have same domains, say HDFC and ICICI bank

    • Suppose ICICI PE is 800/80 = 10, HDFC PE is 80/80 = 1 and their future visibility is same

    • You might say buy HDFC for low PE, however there could be flaws

    • ICICI might not be costly, suppose ICICI is having real earning Rs 800 and reinvesting Rs 720 for expansion and might return even > 800 post expansion (stop reinvesting 720 and earning growth from expansion)

    • HDFC might not be cheap, suppose it got one time earning of Rs 72 due to some win or asset realization. This may turn real PE as 80/8 = 10

    • Conclusion: Flaws of PE, Hidden Real earning (Reinvesting Vs one-time earnings)

Use-Case-3: How to use PE ratios to overcome the flaws of PE

    • Calculate PE of Bank FD = FD of Rs 100\Interest per year say Rs 10 = 10 (risk free)

    • C1 Large Company Suppose PE = 10 (risky since company)

    • Which one to choose with same PE however different risk

    • C1, since entrepreneur is working with vision of increased earning with GDP growth, otherwise would have sold business and invested in Bank

    • Now PE of C1 is not high as people doesn't know\believe of growth potential which entrepreneur might be believing

    • Now suppose we buy C1 being available at discount, and market fear comes true that earnings didn't grow

    • Say, there is new invention which reduced petro use to 0, and C1 collapse

    • However, this will make energy free and people would buy something else with saved money say electronics etc

    • C1 may collapse still the next generation is going to lead a better life upon disruptions

    • If we invest in C1 at discount there may be a chance to loose money(becoming zero)

    • Rule No 1, Protect your capital is not followed

    • Conclusion: Market disruptions may collapse some company however create big earnings for other sectors or company

Use-Case-4:

    • Open a company with 1Cr investment and earn 1L in 1st year

    • PE is 100, why did you invest if Bank could give 10L

    • Justification is risk of 1Cr is taken for higher future earnings, which might be higher than bank 10L earnings

    • PE of risky should be higher than safe bet with higher future earning potential

    • This means use-case-3, PR of C1 should have been > 10 e.g. 15 to signify higher earning with higher risk, Since PE of risky was at par with of safe bet, PE should become more so buy C1

    • Rule No 1, Protect your capital is still not followed

    • Conclusion: Leaving market disruption, better to buy with higher risk with higher future earning potential

Use-Case-5:

    • In previous example we saw C1 could close

    • Now sensex can't become zero, some company would be present in it

    • Why not compare Sensex PE with Bank PE

    • Sensex PE = Price of all companies in Sensex/Earning of all companies in Sensex with weightage in Index , suppose its 10

    • Bank PE was also 10

    • Now PE is same for risky Sensex with high future earning potential Vs Bank, so we should buy Sensex

    • Rule No 1, Protect your capital is followed

    • People who want to know when to buy Sensex Index, when PE of Sensex is similar to Bank

    • Bank FD PE with 6.5% interest rate 100/6.5 = 15

    • Conclusion: When to buy Sensex Index, when PE of Sensex is similar to Bank FD

Use-Case-6:

    • Earlier Bank FD rates were ~8%, Bank FD PE was 100/8 = 12.5

    • When to buy was PE 12.5 earlier, now its PE 15 based on Bank FD interest rates

    • When Bank FD PE used to be 12.5, historically it was considered PE of 26,27,28 as expensive

    • PE 12.5 was logically based on Bank FD rate

    • PE 26,27,28 was only historic, there was no logic attached to it

    • Lets consider for PE 15 cheap, expensive PE is 30 (historic view not based on reason). Average PE = (15+30)/2 = 22.5

Earnings Analysis

How is Price of a Stock effected by the earnings

    • Price = Earning * PE Ratio (Sentiment of market\crowd for that earning)

    • Suppose Sensex Today: 30,000 = 1500 * 20

    • Price could increase by earning or the sentiment

    • 2014 just before election, Earning was 1, PE was low as 10 with uncertainty on govt formation factors (policy etc)

    • Price 10 = 1* 10

    • 2015, after election results price increase 15 = 1 * 15 (sentiment)

    • Price increase 50% by sentiment

    • 2016, assume some reform increased earning (1.5), Price 22.5 = 1.5 * 15

    • 2017, assume sentiment increased (say 20) with same earning, Price 30 = 1,5 * 20

    • 2018, assume earning increase (2) with same sentiment, Price 40 = 2 * 20

    • Conclusion: Best time to invest in market, when both earning and sentiment (PE) are low

    • Conclusion: Bad time to invest in market, when both earning and sentiment (PE) are high

Learnings:

1. PE only tells what's price you are paying for the investment in a company. PE doesn't tell future visibility of a company

2. Flaws of PE, Hidden Real earning (Reinvesting Vs one-time earnings)

3. Market disruptions may collapse some company however create big earnings for other sectors or company

4. Leaving market disruption, better to buy with higher risk with higher future earning potential

Rule:

1. When to buy Sensex Index, when PE of Sensex is < 100/10 year Govt Bond yield

2. When to buy Sensex Index, when PE of Sensex is > (26 - 0.5 - (12.5- (100/10 year Govt Bond yield)))

2. PE has limitation, low PE is logically, however high PE is illogical (historical)

2. Best time to invest in market, when both earning and sentiment (PE) are low i.e.

3. Bad time to invest in market, when both earning and sentiment (PE) are high



Why SIPs are hard to continue

    • Incorrect return analysis

    • Support invest 5,000 for 7yrs (Rs 4,20,000) and FV at the end is Rs 8,20,000

    • First thought comes is money just got doubled, that could happen in Bank as well. What's the benefit. This is incorrect return analysis.

    • Actual returns: =RATE(7*12,-5000,0,840000,), 1.52% per period i.e. month compounded. This means 20% annual return

    • During market downturn, fear make stop the SIP. Instead SIP to be increased at downturn

    • Focus on short-term returns of 2-3yrs, Equity is not meant for < 7yrs investment journey


What make us believe that 15% CAGR is possible for Nifty?

  • Price of asset = Earning * PE Ratio

  • In long term, PE ratio may be volatile 10-30% Avg 20%, however cant have consistent growth

  • Price growth needs to be driven by Earnings, hence earning is driver for price growth

  • Earnings need to be give Nominal GDP growth ~15% (Real GDP 8-9% + Inflation 6%)

  • Developing country target Growth (to provide employment) with wider inflation rate (4 +-2%)

  • Developed country target inflation (low), since they have enough jobs for citizens so growth is not a concern

  • Top company sales should growth as Nominal GDP, and earnings should follow the same

  • Top company represent the Nifty, hence Nifty should grow by 14%


Forecasting the Levels of Nifty

  • Long Term (15 yrs)

    • Rakesh Jhunjhunwala said Nifty to grow from 9k to 125k in 15yrs, i.e. ~20% compounded growth

    • =RATE(15,0,-9000,125000,), 19%

    • Justification was, Nifty grown from 943 in April 2003 to 8600 in Dec 2014 with 20% compounded growth

    • =RATE(12,0,-943,8600,)~20%

  • Short Term (4 yrs)

    • Earning = Price / PE Ratio

    • Price is Sensex price

    • PE Ratio is on bse sensex website => markets => indices

    • Earning 2017 = 33618/24.85 = 1352

    • Use historic earning-change % to determine current phase of earning growth cycle, Lower cycle means next cycle would be higher

    • Earning 2021 projection = Earning 2017 * 1.17*1.17*1.17*1.17 = 2533

    • PE Ratio 2021 projection = Similar 2017 i.e. 24.85

    • Price 2021 projection = E2021 * PE2021 = 2533 * 24.85 = ~62000 (Average view)

    • However path could be volatility, might be lower and higher in between

Create Table for Earning cycle Analysis

||Year||P/E||Price||Earnings||Change In Earnings||% Change in Earnings||