25 June, 2016 14:22 IST


What is a mutual fund?

A mutual fund is a trust that pools the money of several investors and manages investments on their behalf. Legally it is like any other company you know of. Hence, the fund is also called a mutual fund company. The fund company takes your money and like you from other new investors. This is added to the money that's already invested with the fund.

What is a scheme?

A fund collects money from investors through various schemes. Each scheme is differentiated by its objective of investment or in other words, a broadly defined purpose of how the collected money is going to be invested. Based on these broad purposes schemes are classified into a dozen or so categories about which more later.

What are units of a scheme?

When you buy into a scheme of a mutual fund you are holding units of the scheme. Buying units is like owning shares of a scheme.

What are assets of a fund?

Asset, of course, is the investments of a mutual fund. And value is the market value of investments. What exactly is market value? Let`s say a fund has invested its money in stocks. Then, the price of those stocks on the stockmarket multiplied by the number of stocks owned gives you the value of all the investments made by that mutual fund. This value can change either when the market valuation changes or if people are joining or leaving the scheme.

Does a bigger asset indicate a more popular fund?

Some investors see asset size as an indicator of popularity. A scheme with large assets could be subscribed to by large number of unitholders.

Are big funds with more unitholders always better?

Popularity has a flip-side which works against the funds many times. Consider this: If under some circumstances, a large number of untiholders decide to sell i.e. redeem, their units all at the same time, the fund will have to, at a short notice, generate enough cash to pay up the unitholders. The fund manager then faces what is called redemption pressure. He would have to sell off a significant portion of the scheme`s investments. If the markets are down the sell off could be at a throwaway price. Naturally then, more the investors in a scheme more the chance of a sudden redemption pressure.

What is an asset management company?

Investing and managing the collected money is a difficult task. The fund company delegates this to a company of professional investors, usually experts who are known for smart stock picks. This company is the Asset Management Company (AMC) and the fund company usually delegates the job of investment management for a fee.

Can a sudden change in asset size affect performance?

Asset size also matter in case of small funds when they suddenly become big. For example, the excellent handling by the fund manager of a small fund may suddenly become popular and draw a lot new unitholders. The sudden flush of funds could lead to a change in the manager`s investment style that might record a drop in performance.

What makes mutual funds a diversified investment option?

A mutual fund may not be able to meet the investment objectives of all unit holders through just one portfolio. Some unit holders may want to invest in risk-bearing securities such as equity, while others may want to invest in safer securities like bonds or government securities. Moreover, there are so many varying risks associated with different securities that it is often impossible for one individual to manage them. Therefore, a mutual fund tries to create different classes of risk portfolios by formulating different investment schemes. Each investment scheme specifies the kind of investments the scheme will make out of the monies collected.

What are stocks? What is equity?

Quite simply, if you own a stock of a company, you own a piece of the company. Equity is the part ownership of a company in the form of its stocks.

Are stocks and equity the same thing?

We use equity and stocks interchangeably. Equity refers to ordinary stocks. And that`s what concerns us here because only ordinary stocks can be purchased by individual investors and traded on the stock exchanges. Stocks again refers to equity. Unless we mention preference stock, stock is always for the equity stocks.

How do stocks get created?

Worldover, people who start a company usually do not have enough money to kick-off. So they look elsewhere and try to rope in others to chip in. They divide the entire capital that the company needs into a large number of units of easily affordable amounts. For example, if a company requires a capital of Rs 1 crore, it may divide it into 10 lakh units of Rs 10 each. Such units are called stocks and Rs 10 is known as the par value of the stock. Thus, anyone with a few hundred rupees to spare can invest in the company.

How does a company benefit by raising money through stocks?

There are two obvious benefits of raising money this way. Firstly, it lets an entrepreneur think of starting a business even if she does not have all the money required. Secondly, it allows small investors to participate in wealth creation and benefit from an important economic activity.

What are American Depositary Receipts (ADR)?

These are shares of non-US companies traded in American stock exchanges in US dollars. ADRs work like any other share that we know of only that they are negotiable receipts held in a US bank representing a specific number of actual shares called ADS. For the American public ADRs simplify investing. So when Americans purchased Infosys stocks listed on Nasdaq, they could do so directly in dollars, without converting them from rupees. Such companies are required to produce financial results according to a standard accounting principle, thus, making their earnings more transparent. An American investor holding an ADR does not have voting rights in the company.

What are the two types of stocks?

There are two kinds of stocks, preference and ordinary.

What is an ordinary stock?

Ordinary stocks sometimes also called equity stocks or common stocks, are really for the general public without any bar. You, me and just anyone can buy them (and proudly say we have a stake in the company). Individual investors can only acquire ordinary stocks. Holding equity stocks makes you apart owner of the company and entitles you to a share of the earnings and the assets of a company. Payment of dividend is not assured in case of ordinary shareholders.

Do ordinary shareholders get dividend?

If a company records profits for a year an ordinary shareholder is entitled to a share of the profits. The share of the profits or earnings, the company is supposed to give is called dividend. How nice! But did you get the catch when we emphasised on entitled and supposed? Because what happens is that ordinary shareholders will only get the dividend after everyone else, i.e. once the company owners and the preference shareholders have settled their share of the earnings. So, if the company chairman says no dividends this year, you can't kidnap him till he comes out with your dividend unless of course, you have no other way to earn infamy.

What are preference stocks?

There are two kinds of stock, preferred and common. Preference stocks are a cross between equity stocks and bonds, which have an assured dividend. Preference stocks are generally given out to banks, financial institutions and rich guys with high net worth.

Are preference shareholders preferred?

Preference shareholders are privileged guys. They get their share of the earnings before the ordinary shareholders. In other words, preference stocks will always have an assured dividend. Whether those shareholders actually get paid depends on whether the company has enough resources to pay up. If that was not enough, those privileged guys also have the "added" advantage. All their missed dividends keep getting added while for ordinary shareholders dividends once missed are missed forever! And when the company does declare windfall profits, it will first pay the cumulative dividends of the preference shareholders and then the ordinary shareholders.

Can you redeem ordinary stocks?

Ordinary stocks are not redeemable. Once out of the company's kitty, the company doesn't have to repay for the equity stocks until it shuts down. Hence, for a company equity shares provide it permanent capital. One fine day if you decide to get rid of the stocks of a company, you can`t walk into the company and tell them to buy back or redeem the shares from you.

Are preference stocks redeemable?

Preference shares are redeemable. The company can repay the shareholder in return for the stocks. The amount repaid in most cases includes the premium over the current market price of the stock. Usually preference stocks are issued to shareholders for a particular period. A company can also, if it feels its too costly to keep paying dividends, buy back preference stocks after serving a proper notice to the stockholders. However, there is also a non-redeemable variety of preference stocks where such stocks can only be redeemed at the time of a company's liquidation.

Can preference stocks be traded?

Though legally preference shares can be listed on exchanges, nobody has ever done so and hence, there is no trading of these shares. This means that preference stocks don't appreciate as much as ordinary stocks do.

Can ordinary shares be converted into preference shares and vice versa?

No. There are some convertible types of preference shares that allow the shareholders to convert such stocks into ordinary shares after a particular period or after fulfilling certain conditions.

What makes ordinary stocks better than preference stocks?

Unlike ordinary stocks, you don't get to trade preference stocks on the exchanges. That means preference stocks don't appreciate as much as ordinary stocks do.

What happens when a company shuts down?

All that is solid melts into air. Apparently healthy companies sometimes wind up all of a sudden. As a part owner, all shareholders get paid according to their stake in the company. Ordinary shareholders will be the last to get paid. All debts of the company must be settled first, including the claim on the assets of a company by the preference shareholders. It could well be that ordinary shareholders get nothing if no assets are left after clearing off debts and paying preference shareholders.

What does redeeming a stock mean?

Let's say quits! Enough of investing and now you want your money back. To redeem is to get back the principal (i.e. the price at which you purchased) in any security like a bond, a preference stock, or a mutual fund share before or at the time of maturity. For a company or an institution that issued you the security, redemption then means, quite simply, buying back the security. Ordinary stocks are not redeemable. Only preference stocks are redeemable.

What is margin trading?

Buying or selling of stocks on credit is margin trading. In margin trading you either buy long, i.e., borrow money to buy shares at a lower price and hope to recover the costs by selling at a higher price, or sell short, i.e., borrow stocks and sell them at a higher price and recover costs by buying them at a lower price. Both short-selling and buying long require a good reading of the market and correct timing.

What`s the advantage of buying long?

Buying long allows you to buy more shares than you can afford. And, if your hunch about a stock's price rise turns out to be correct, you stand to gain more than what you could have without a margin buy.

Why is buying long risky?

Buying long becomes risky if your calculations go wrong. If it takes much longer time for the stock price to reach the level than what you had estimated, your profits will reduce because by that time the interest cost on the borrowed money would have also risen. And if your estimate completely goes wrong and the stock's price falls you immediately start making losses. To be safe the stock price should rise enough to pay off the loan amount, the interest incurred and the transaction cost.


The other type of margin trading is short-selling. "Going short" is opposite of buying long and investors do it when they expect the price of a stock to fall and profit from this drop. Lets say, you tell your broker you want to short-sell 100 shares of Tata Tea which are currently priced at Rs.40 each. This quarter's results of the company aren't encouraging enough and you are convinced the stock price will take a beating. The broker looks for someone who has 100 shares of Tattoo Tea and borrows them on your behalf. You in turn sell these borrowed shares at Rs.40 each and hence get Rs.4000. Now, if what you had hoped for does happen, and the price of the stock falls to say Rs.20 after a week, you will do what is called "cover the short position". That means you buy back the 100 shares by spending Rs.2000 and your broker in turn returns them to the person borrowed from. So, by short selling you have earned Rs.2000 (of course, slightly less after adjusting for the transaction costs and expenses for borrowing the stock).

How does selling short help?

The advantage of selling short is that you get to sell borrowed stocks without putting in your money.

Why is short-selling risky?

Short selling can be perilous. Suppose if the Tattoo Tea shares fall but only do so marginally, you might just be able to recover your money. Or if the shares take a much longer time to reach the Rs.20 level than you had hoped for, your interest on the money with which the broker had borrowed those shares will surmount. Additionally, there will be constant pressure from the lender to return the stocks. Worse still if instead of falling the stock price rises, you will immediately enter into a loss.

What is a margin call?

In both cases of margin trading you are actually trading shares on credit that you have taken from the broker. If you have bought or sold a stock on margin and the stock's price reaches a level that makes it difficult for your broker to recover the credit, your broker will give you what is called a margin call. The broker might ask you for more collateral in the form of stocks or ask you for additional funds. If it becomes worse the broker will sell the stocks, in case you had gone long, and ask you to repay the loan.

How does one make money through stocks?

One can make money through stocks in two ways: either through dividend or through capital appreciation.

What is capital appreciation?

One way of making money through stocks is capital appreciation. A week later if the stock price of the scrip you hold has doubled to Rs.20, by selling it you have earned a return of Rs.10 as capital appreciation. You have made money by a 100% appreciation in the stock`s price. Through this way your fortunes will perpetually keep fluctuating. That`s because it depends on the stock`s price, which is always on the move even if fluctuations are incremental. Chances are most of the times your invested capital is getting appreciated but the value could also dip.

What are dividends?

Another way to make money through stocks is dividend. The company whose stock you own may have made huge profits which it will have to share with all stockholders. Such shared profits are called dividends. Being ordinary shareholders, as we told you, you might or may not get dividends, hence, this bit of earning through stocks is not assured.

Why do shareholders sometimes prefer not to opt for dividends?

Dividends can be a good earning, more so because they are non-taxable in your hands since now only companies have to pay tax on the dividend they disburse. Shareholders sometimes prefer to do away with dividends. This is specially so for small and fast growing companies. Investors in such companies feel it is better to plough back the earnings for growing the business rather than distribute as dividends.

How to benchmark a stock?

Consider this: when you buy potatoes from your neighbourhood vegetable market, with a short survey you can ascertain what the prevailing rates for different qualities of potatoes are. The same becomes impossible when you go to buy stocks. Each stock has a unique price and unlike potatoes, cannot be clubbed as `a particular quality of stocks`. A good enough way to benchmark your stock is the market index.

What is a market index?

An index is a composite of stocks that indicates how the overall market or a part of the market is moving. The grandfather of all indexes in India is the Sensex.

What is the Nifty?

The National Stock Exchange has an index, the S&P CNX Nifty. Since its inception this index, also called the Nifty Fifty, has attained great popularity among investors. Hundreds of calculations are made before 50 stocks of the NSE are selected for the index. S&P stands for Standard and Poor, a subsidiary of McGraw-Hill, and an investment advisory service that maintains one of the most widely followed benchmarks of stock market performance, the S&P 500 index. The CNX stands for CRISIL NSE Indices, the two companies that came together to form the index.

What do S and P and CNX stand for in S and P CNX Nifty?

S&P stands for Standard and Poor, a subsidiary of McGraw-Hill, and an investment advisory service that maintains one of the most widely followed benchmarks of stock market performance, the S&P 500 index. The CNX stands for CRISIL NSE Indices, the two companies that came together to form the index.

Why should one analyse companies while analysing stocks?

What happens to the company affects the price of its shares on the stockmarket and hence, your investment. The legendary investor Warren Buffet (incidentally, once the second richest man in the world) says that he never invests in a company whose business he doesn`t understand. As investors, we will do well to follow his practice. So, knowing about companies is the first essential step in investment. You will need to know the business a company is in, and how is it doing both in absolute terms and in comparison to other companies in the same business. To do that, you have to look at the financial performance of companies and pick up the star performers. You will also need to look at the future of the business itself. Is it nearing the end of its life cycle? As investors, we hope to participate in a business with a lot of scope for growth.

How does the performance of a sector affect a stock`s performance?

We need to look at the performance of the entire sector. Whatever for? After all, we aren`t investing in sectors. We`re putting our money in companies and we can get to know them by looking at their performance. Right? Well, look at it this way. Take your own profession. Doesn`t what happens to others in the same profession affect you too? If you are a banker and you see other banks laying off employees, you bet your last rupee you`ll start worrying whether your bank is the next in line to start downsizing. So, what happens in the banking sector concerns everybody with a stake in that sector.

What risks does the company you have invested in, face?

Just like employees, investors too have a stake in the sector in which they have invested. As an investor, you wish to know the risks your company faces. These are of two types -- one that is peculiar to the company and can be controlled by it (called a unique risk), and the other which is more pervasive and often beyond the company`s control (called a systematic risk). We need to know about both kinds of risks to plan our investment strategy. For example, if the steel sector is not doing too well at the moment (a systemic risk), you may wish to move your investment out of a company in this sector.

How does the state of the economy affect stock prices?

A company operates within the broad framework of the economy. Its future is closely linked with the performance of the economy. This is due to the interdependence among various industries and sectors of the economy. Take the steel industry again. To do well, it needs a good demand for its products. Now, suppose the automotive industry or the construction industry is not doing well. Will that affect the steel industry? Of course, it will, because both automobiles and construction industries use steel. If these sectors are not doing well, the demand for steel will drop, affecting the performance of the steel industry. The indicators on the economy allow us to track general trends in the economy. If they don`t look very healthy, we ought to be cautious as investors.

What methods do professional analysts adopt to analyse stocks?

Professional stock pickers adopt different processes to analyse stocks. Some adopt a method in which they begin at the general and then zoom in to the specific i.e. they would probably begin with an analysis of the economy. While analysing the present state of the economy they would look at interest rates, what economic outlook the finance ministry projects for the short term and other political events that might have a bearing on the economy. Having reached at a conclusion about the economy, the professional will choose industries that he expects will perform well under the given economic conditions. Next, he hones in on some of the companies in the industry, sees how the companies are performing and then evaluates their stocks. The end product of such an analysis is to convincingly answer one question for his investors: Is the price at which the stock is currently selling worth it? The other method works in the reverse way in which the professional analyst picks up a stock, looks at the current and historic performance of the company, then studies the industry and finally takes an overview of the economy.

What is a good debt-to-equity ratio for a company?

A debt-to-equity ratio is a measure of a company's leverage, calculated by dividing long-term debt by common shareholders' equity. The ratio for a company depends on the industry it functions in. A high ratio indicates a good chance that the company won't be able to service its debt in the future. However, the company's debt/equity ratio should generally be below the industry average.

How do I know how profitable a company is?

Operating margin and net operating margins tell us about the profitability of a company. In mathematical terms they are ratios expressed in percentages of the company's gross profit and net profit to the sales, respectively.

Good growth rates sound good, but what else do they tell?

Just impressive sales and profit figures don't impress many investors. They also judge a company by its growth rate i.e., rate of growth in sales as well as profits. A fast growing company has good capital appreciation. Good growth is also a reflection of quality management. One also checks for growth rate figures to be consistently above the industry average.

What price levels should one look for in a stock`s past performance?

The 52-week high and the 52-week low. These levels tell the highest and lowest price of the security for the past one year. It's prudent not to buy the stock if its current price is around the 52-week high and not to sell it if the price is around the 52-week low. The current price of the stocks should lie between these two values.

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