The Tribune, Chandigarh, India

Follow the basics & be smart investor
Arun Thukral

In his book, Winning the Investment Marathon, Brad Perry wrote that investing “is pursued most successfully in a simple, straightforward way.” This is the Golden Rule for most investors who employ fundamental analysis and have a long-term perspective. Invest in high-quality companies (good governance, solid fundamentals) at good prices and continue holding them as long as the companies’ performance merits doing so. One might hear of different ways to buy and sell stocks, and countless books have advocated systems that assure great returns. But it is fundamental analysis that works in building wealth over the long term.

The fundamental questions:

Is this a properly managed company?

Is its stock fairly priced?

How are the company ethics and corporate governance?

Investors should look for good quality management because it is these capable administrators at the top who know how to ensure their company survives and grows over the long term amid competition and cyclical downturns. These are the people, who are responsible for driving the sales and growth of the company stocks.

A first step in finding a well-managed company is to look at the history of sales and earnings growth over considerable period covering at least one good and bad cycle, say 5 or 10 years. An important indicator of strong management is its ability to grow the business in good as well as bad times. In a country like India, one has to look for companies that have reported long-term sales and earnings growth at a rate that is higher relative to their size. Smaller companies generally should be growing earnings by a minimum of 15% per annum; mid-size companies, between 10% -15%; and large companies, by at least 7% annually.

Higher growth rates from smaller companies are expected partly because they generally are riskier investments than large companies. The higher growth rate compensates for this additional risk; if one is able to identify good small companies he shall be rewarded with significant returns.

Additional parameters that aid in evaluation of management quality are profitability before taxes and other charges outside of management's control and return on equity. An investor has to prefer companies with constant or growing profit margins and stable return on equity.

Comparing growth, profits and return on equity among peers will help identify whether the company will survive in the long term or is simply beneficiary of current rising tide for its industry.

Appraising the investment potential

Fundamentally, one knows that good companies may not be rewarded by the markets in the short term but excellence will be appreciated over the long term. Thus, the projections are for a period of approx. five years — sufficient for the company to go through a business cycle — that one has to care about. Historical data is an important indicator used by both beginners and experienced investors. Using historical data points that we have analysed and understood, we start by forecasting sales growth. The various data points are:

Company's historical growth rate;

Company reports - quarterly updates / annual reports indicating growth goals.

Consensus analyst estimates both short and long-term growth.

Industry's historical growth rate and estimates of future expansion - available in annual reports and industry associations' journals/website.

Other factors which may be considered by veteran investors are:

The percentage of recurring revenues

Projects yet to be completed

Organic growth and growth via acquisition

In retail -same-store sales growth, expected store and square footage expansion.

The next step is to estimate earnings growth with regards to projected sales. With the historical sales and earnings achieved by the company, we compare the company's growth goals it has stated in annual reports/ analyst meets/ earnings conference calls.

Analysing past and likely future profit margins along with tax rates can help us understand the path revenues will take to earnings. One should also consider common shares outstanding. For example, if a company regularly buys back shares thus reducing the number of shares outstanding and is estimated to continue this practice, then future earnings to be spread among fewer shares.

Two things to be kept in mind about projections

It's prudent to be conservative:A company may have historically grown at a rate say 25% over the past 7-10 years; however as the base increases such performance may be difficult to maintain. The base effect eventually will affect when a company moves from small to mid-size to large.

Earnings growth may be higher than sales growth in the short run but in the long run, they usually settle in at the rate of revenue growth.

Checking Valuation: Once the earning per share (EPS) five years from now is forecast, one is in a position to answer, the second question: Whether the stock is reasonably priced. Discovering a high-quality stock is relatively less challenging than determining the proper price to pay for the stock. Firstly, one should analyse the stock's price to earnings ratios over the past several years and forecast the likely P/E's at the higher and lower end over the next five years. The P/E, calculated as stock's current price divided by a company's EPS, indicates how much the market is willing to pay for Rs 1 of a firm's earnings. It is the most common way to measure how expensive a company's stock is.

Historical valuations can help us in this process, but P/Es often go through volatile periods of expansion and contraction depending upon industry cycles, economic scenario and investor preferences. Additionally, a stock may trade at extremely high P/Es for a while but eventually will drop drastically when a high-growth company stumbles. P/Es also tend to contract in inflationary periods.

After estimating the high P/E for a stock, one can estimate a potential high price for our stock. The high point of EPS — what we forecast the EPS to be five years from now — is multiplied by the high P/E to arrive at a potential high price.

Return expectations

After determining the high-low range, investor can analyse whether the
stock will provide a suitable return. This can be divided broadly into three zones: Buy, Hold and Sell. The lowest 25 per cent of the range is the buy zone, and the upper-most 25 per cent is the sell zone.

While calculating stock return, one should also consider dividends paid by the company. Thus, investment in stocks can give return in three ways:

Through dividends

Appreciation of stock's price due to earnings growth

Appreciation in stock's price due to P/E re-rating; the market believes the P/E should be higher.

Normally, one should seek stocks to return around 15% CAGR over the next five years or a doubling of return. Though the target may seem aggressive, the idea is to find out high-quality growth stocks. Realising 10% yearly returns is also satisfactory.

Managing risk

Some simple rules to follow while picking individual stocks:

The company should have at least five years of financial history. New firms may not have developed enough of a track record for assessing management performance.

Study companies that have proven track record of making money. Investing in a company that has never reported earnings is speculating.

Understand the possible risk and reward of owning a stock.

Diversify your portfolio

You may make an error in spite of taking an informed decision. Diversification into various stocks will lead to better performance. Apart from investing in high-quality growth stocks and diversifying your portfolio, two additional simple principles can help you build wealth in the long term.

Reinvest all your dividends and earnings.

Invest regularly in both good markets and bad; this is also known as cost averaging.

This analysis provides lot of information required by a fundamental investor to take an informed investment decision, however, it is not everything. Updating oneself about events concerning the company, news, economic developments, and viewing company presentations will help you to form a complete picture of the firm.

The author is MD & CEO, Axis Securities. The views expressed in this article are his own

tax advice
No tax on gift to spouse
SC vasudeva

Is there any tax liability on a husband if he gives a gift to his wife and vice-versa? Can one get a tax rebate on contributions made to an LIC or a pension fund, when the beneficiary is minor/major daughter’s daughter or daughter's son and or a married daughter or a son etc.?
Bank deposits exceeding a period of five years or more or interest earned by such instruments within the ceiling of Rs 1.5 lakh are exempted. Does it also include Post Office MIS accounts, where term is six years? — sagar chand

Your queries are replied hereunder:

A husband can gift any amount to his wife without any tax liability. However, the income earned on the gifted amount would be clubbed with the income of the husband. A gift by wife to a husband is also exempt from tax, but the income earned on the gifted amount would be clubbed with the income of the wife.

Section 80C of the Income Tax Act, 1961, (The Act) covers the deduction for any amount paid by an individual to effect or to keep in force an insurance on his/her life, his/her spouse and any child of such individual. Such deduction is subject to a maximum amount of Rs 1.5 lakh specified in the said section. This limit is applicable from the Assessment Year 2015-16 (Financial Year 2014-15). The child may be major or minor. Therefore, a married daughter and a married son would also be covered in the aforesaid category. However, daughter's daughter or daughter's son would not be covered for the purposes of claiming deduction under Section 80C of the Act.

The deduction in respect of contribution to a pension scheme of the Central Government is allowable under Section 80CCD of the Act to an individual who has paid or deposited any amount in his account under the pension scheme notified by the Central Government. The account has to be in the name of the contributor only. It may be added that the deduction under this section is limited to Rs 1 lakh. The overall limit for all deductions allowable under Sections 80C, 80CCC and 80CCD is Rs 1.5 lakh.

The deduction under Section 80C of the Act is allowable in respect of a long-term deposit for a fixed period of not less than five years with a scheduled bank in accordance with the Central Government Scheme notified in this regard. The interest on such deposits is not covered within the provisions of the aforesaid section.

n A deduction is also admissible under Section 80C of the Act in respect of a five-year time deposit in account under the Post Office Time Deposit Rules, 1981, within the overall limit of Rs 1.5 lakh.

I have lost Rs 42,000 on the sale of shares within a year of their purchase and Rs 12,000 on the sale of shares retained for period of more than one year. Can I carry over the total loss of Rs 54,000 to the next year i.e 2009-10 (Assessment year 2010-11). — alok

The loss of Rs 12,000 suffered by you on the sale of shares which had been held for a period of over one year is a long-term loss and can be set off against long-term gain provided the gain and loss is not in respect of shares of a listed company and on which securities transaction tax has been paid at the time of sale. Presuming that the loss is not in respect of a listed company, the same can be carried forward for being so set off for eight years immediately succeeding the year in which the loss was first computed.

The loss of Rs 42,000 in respect of shares held for less than one year will be treated as a short-term capital loss. It can be set off against short-term gain or a long-term gain which is not exempt from tax under Section 10(38) of the Act. Such a loss is also allowed to be carried forward for eight years for being so set off. The answer to your query is based on the presumption that you were not carrying on a business of purchase or sale of shares and the loss on the sale of shares is in respect of the shares held as investment by you. It may be added that the carry forward of such losses is allowed if the return is filed within the time limit prescribed under Section 139(1) of the Act.

Enjoy financial security with life insurance
Kshitij Jain

It is common to be blessed by elders with a long and happy life in most Indian households. But with the changing times of nuclear families, inflation and increased longevity, living a long and healthy life comes with a significant cost. Yet, for many, this realisation has still not sunk in and we still have a long way to go before Indians grasp the situation that they face.

The Ministry of Health and Family Welfare’s data states that the life expectancy in India has gone up by five years — from 62.3 years for men and 63.9 years for women in 2001-2005 to 67.3 years and 69.6 years, respectively, in 2011-15. And going by past trends, those born in the last couple of years are likely to live longer than those born a decade ago. With time, this longevity is only going to keep increasing albeit at a slower pace with the advent of better healthcare and nutrition.

A lot of what the current generation faces is to do with the changing society dynamics, especially the end of the joint family system. In earlier times, which is still the case in smaller towns, it was a given for the older generation to be taken care by the younger generation and the cycle went on. Today, we live in the reality of nuclear families, which has made it necessary for each of us to prepare well so we can fend for ourselves in our later years. The financial implication of this change in our society is immense.

We not only need to take care of our immediate financial dependents, but also our own future financial needs to lead a life of dignity post retirement. The rise in the cost of living and healthcare costs further adds to the financial strain that we will face as we get older.

In the midst of the gloom rests a financial product which addresses the financial risks associated with a long life. Life insurance is the solution that will help you manage the financial needs of your dependents in case of an eventuality. At the same time, it can help you manage your finances in your retirement when you need money the most. While most people think of life insurance only as protection for their financial dependents, they do not realise that they also need to protect their own future. In a single stroke, you have the solution for the dual problem of protecting your dependents and creating a cushion for your long life post retirement.

Although, there can be no way to compensate the loss of life, a life insurance plan does ensure that your family's financial situation is not impacted adversely in your absence. The other way, insurance works is helping you create a corpus that gets accumulated through your working years to be utilised when you need it the most-in your retirement. Life Insurance comes with its proposition of products that go beyond protection and ensures you have a long and financially sound life.

The author is MD & CEO, Exide Life Insurance. The views expressed in this article are his own