Mutual Funds - Importance of Debt Mutual Funds

It is very important to understand how to invest your hard earned money. This money in turn can be useful in every other situation if invested properly. Therefore I have created a case study which helps in understanding importance of mutual funds (one of the important investment vehicles) which is as follows:

CASE STUDY

55 yr old man , director for  a leading pharma company. Existing assets include ESOPs from his current and previous employer ( both Pharma companies ) worth 4 Cr. Fixed deposits for 4 Crs, and 40 lacs of equity mutual funds. Survived by two sons who are working and wife who is a home maker.Recommend options that maximize his portfolio returns . He has term insurance for 2 Crs and intends to retire at age 60 . He requires 2 lacs per month for maintenance and expects to survive till 85 yrs.

Portfolio Construction for the Case Study:

Assets currently Owned

ESOPs worth 4 Crores.

Fixed Deposits of 4 Crores.

Equity Mutual Funds – 40 Lakhs.

Term Insurance – 2 Crores.

What the Client requires?

2 Lakhs per month for maintenance.

About the Client

The client is at the age of 55 years. At this age, the risk profiling of the client doesn't allow him to invest a large amount in equity. Therefore the portfolio has to be constructed in such a way that 90% - 95% of his savings have to be under safe investments such as debt investments.

Let’s look at his assets along with the advantages and disadvantages.

Employee Stock Option Plan

Stock Option is ownership in a company which means that client owns a part of company in the form of shares which is an equity component. Given his age, 4 Crores of equity investments involve a high risk. He owns the shares (ESOPs) of pharmaceutical companies (Both his previous and current employer) of worth 4 Crores which is not advisable as the stock of the pharmaceutical companies are very dynamic in India due to the following reasons:

·         Regulatory obstacles

·         Lack of proper infrastructure

·         Lack of qualified professionals

·         Expensive research equipments

·         Lack of academic collaboration

·         Underdeveloped molecular discovery program

·         Divide between the industry and study curriculum

·         Parallel drug in the market (Loss of Market size)

We shall look at the required investment plan later in the case study.

  

Fixed Deposit of 4 Crores

Fixed Deposit is considered to be one of the safest investments in India. The Client has a very minimal risk if he invests in fixed deposits but at what cost?

Assume the Client invests in a Fixed Deposit which yields him 9% on the 4 Crores investment he made.

The amount earned on interest per annum is 36,00,000/- (9% of 4,00,00,000)

Since he falls under the highest income tax bracket he has to pay tax of 30% on the interest income which is 10,80,000/- (30% of 36,00,000)

Bank deducts 10% on the interest income as TDS which amounts to 3,60,000/- (10% of 36,00,000)

Therefore the balance tax paid by the Client as Self Assessment Tax is (10,80,000 – 3,60,000) which is 7,20,000/-

This amount is a big amount and shouldn’t be paid as tax by any individual and in this case, the client who is nearing his retirement cannot lose 7,20,000/- per year in taxes.

Above all the complete amount is locked in for a certain period and includes penalty if redeemed before maturity.

Equity Mutual Funds

Investments in Equity Mutual Funds is one of the best things to earn a super normal profit but only for those people who fall in the age between 20-27 (age may vary few years depending upon the person’s goals and responsibilities). More returns are possible in equity investments because more risk is being taken (though it is not the only reason) but even if the person lost the money, he can recover himself from the loss given his age. But the client at the age of 55, having equity investments of worth 45,00 000/- which is not advisable because  it’s a risky investment.

Term Insurance

Term Insurance of 2 crores is a very good plan by the client which adds security for his wife and children. One more thing the client has to do is to take a medical insurance policy so that he will be covered. This medical policy which the client takes, its premium can be funded from the cash obtained through ESOPs (converting ESPOs into debt scheme and returns from debt schemes).

Suggestions for the client:

Mutual funds are one of the best investments which can be considered and most importantly debt mutual funds in this case.

Therefore client should opt for the following funds:

·         HDFC High Interest Fund – Dynamic Plan (G)

·         Axis Capital Protection Oriented Fund - Series 2 (3 Years) (G)

HDFC High Interest Fund – Dynamic Plan (G)

This is an open – ended long term debt fund provided by the HDFC Asset Management Company. The following reasons are considered for the selection of this debt fund:

·         CRISIL rating agency rated this fund with 5 Stars.

(This shows that the fund has invested in bonds which are safe as it gets)

·         It’s an open – ended fund.

(This means client can enter and exit anytime he wants with no entry/exit load{exit load=0.5% if redeemed within 3 months})

·         It is a debt fund

(This states that the fund operates on a very low risk)

·         Assets under Management (AUM) is 17,354.7 crores.

(This helps in understanding the liquidity of fund and the client doesn't face problem regarding withdrawal as it is highly liquid and the cash is readily available)

·         The fund’s benchmark is CRISIL Composite Bond Fund.

·         The return on fund is 15.3%. The average of similar debt funds is 11.6% and this fund has performed better than the average with exceeding the returns of 3.7%.

·         Expense Ratio is 1.57%

(The cost for the mutual fund to run the scheme is low)

Current Net Asset Value of the fund is 48.103

The fund has invested a large amount in GOI bonds which are safe.

Following is the pie chart which depicts the fund structure:

Fund Managers

Anil Bamboli

Anil Bamboli is working with HDFC Mutual Fund. He has 16 years experience in the mutual fund industry has been in area of Research and Fund Management. Previous to HDFC AMC, he worked from May 1994 - July 2003 with SBI Funds Management Pvt. Ltd. Last Position held - Asst. Vice President.

Shobhit Mehrotra

Prior to joining HDFC AMC, had worked with Templeton AMC as AVP and Portfolio Manager (Fixed Income). He was Business /Investment Analyst, Member Executive Rating Committee.with ICRA

The client can invest in the HDFC High Interest Fund – Dynamic Plan (G). The client should sell ESOPs and convert it into cash and put the entire amount in the above mentioned fund. Then he can opt for SYSTEMATIC WITHDRAWAL PLAN. This plan, if opted, funds the client’s account weekly/monthly/ yearly with the amount desired by the client which is 2,00,000/- in this case and the rest of the amount will remain invested in the above fund earning an interest.

The tax on capital gains is low when compared to the taxes levied on bank’s fixed deposits. The minimum lock in period for the fund to avoid tax on capital gains is 3 years. As the client has 5 years of service, he can relax by putting this amount and by the time he retires, the 3 year lock in period will come to an end and tax on capital gains will be much lesser. Till then, he has his salary to fall back upon.

According to the current NAV of this fund, the number of units the client gets is (40000000/48.103) which is 831548.97

The Client has to withdraw 4157.74 units every month for his monthly maintenance.

One thing the Client has to understand is that the fund is a long term debt fund and bears the risk of interest rates. For example: If there is a BOND A with 9% of interest rate in the year 2015 and BOND B with 10% interest in 2016 then, the value of BOND B will fall because investors will opt for BOND A so that they can pay less interest. Therefore, there is always an inverse relationship between bonds price and interest rates. If interest rate rises, the bond rate falls and vice versa.

From the fixed deposits which client has, he is mostly looking for the preservation of the capital. The biggest disadvantage of the FD is taxed levied on it as mentioned with an example earlier. Therefore the amount present in FD can be transferred into a capital protection scheme mutual fund such as:

Axis Capital Protection Oriented Fund - Series 2 (3 Years) (G)

The main reason for selecting this fund is because it provides the protection for capital and a very small amount is invested in equities for capital appreciation.

For example: If the Client invests 10,000/- in a capital protection scheme with 10.725% interest rate for four years. Only 7,000/- amount can be invested in the capital protected scheme and remaining 3,000/- can be invested in equities. The 7,000/- amount with interest rate comes up to 10,000/- in four years along with the 3,000/- amount invested in equities. Here, the capital is preserved anyways and if there is any appreciation on the equity component, the client is at an advantage.

The AUM for this fund is 7.94 Crores.

Therefore, the client can preserve his capital under this fund and also have an equity advantage if he invests in this fund with the amount which is invested in FD. There is a lock in period for three years and tax advantage as well when compared to fixed deposits.

(Please note: The information of this fund is not given in the internet websites and due to this difficulty, I couldn’t perform more analysis on the same. I just wanted this idea of capital protection to put forth.)

The 45lakhs which he has invested in equity mutual funds is also a risky investment. Looking at the current scenario of the stock market and Nifty performance, the stock market will fall further more as the Nifty P/E multiple is at 22.4. The Client can be asked to wait and watch till the market corrects and then start investing in a debt fund through SYSTEMATIC TRANSFER PLAN (STP). STP helps the Client to transfer money from equity fund systematically into a debt fund.

Conclusion

Client should create an investment plan for his wife in case of any unforeseen situation so that she can be secured with a monthly income generation for her as well.

The client also must understand the longevity of his survival and must manage the same by parking some funds in case he starts surviving for more than 85 years.

Finally, the client must understand how much amount he is receiving from all the debt / capital protected schemes and write a will which includes his wife and after she is no more, the amount and property whatever available goes to his sons as per the client’s desired proportion.

Disclaimer: The investment advise above is just an example and doesn't hold for every other investor. These are completely based on my opinion and I would request you to seek advise from an Independent Financial Advisor before investing.

Infosys announces bonus shares – What should Investors look for?

Infosys (INFY) is the India’s second largest IT services exporter multinational company. The recent announcement of issuing bonus shares was an interesting point which the firm put forth. The reasons for announcing the bonus shares might be:

·         To improve the liquidity of shares in the market.

·         To help investors understand that the firm is looking positive and has many future plans under its belt.

·         To expand the equity of the company.

What the investors should understand:

·         Issue of bonus shares doesn't increase the value of shares.

o    For example: Consider a firm whose share is valued at 200 and it announces a bonus share of 1:1. i.e. for every one share that the investor possesses, he is given an additional share. The point here is the value of share is halved in this case which brings down the share value to 100 and as the investor has two shares now, his overall capital invested is 200 again which is same as the value of single share before the bonus share announcement.

This is one of the important points that investor has to understand. No doubt, this in turn increases the liquidity in the markets with respect to the firm.

Should the investor go ahead and invest for a long term in Infosys?

The quarter results announced by Infosys did not beat the street estimates. The bonus issue should have given the investors’ confidence in the firm but one can see that there has been a sell off of about 6% on the Infosys stock on the same day when the announcement was made.

Let’s get into little fundamental and financial analysis.

Profit Before Interest and Tax & Profit After Tax

Figure 1

(The values are in crores)

As we can see from the above graphs that the PBIT and PAT are decreasing year on year while the profits of industry competitors have been increasing. The reasons might vary such as financial conditions in US markets, rupee appreciation and economic factors etc.

Certain factors which made Infosys lose its prior sheen are as follows:

·         High attrition rate despite of two wage hikes in last one year which rose to 18% from 16%.

·         Over the last 12 months, Infosys has lost several board members such as its BPO’s head, sales head and two presidents who resigned from the board.

·         Researchers say that Infosys is over-dependent on the North America for revenues.

·         The growth has not been consistent as per the figure 1 above.

The capital used for the issue of bonus shares is from the firm’s reserves and surplus which again decreases the reserves and surplus amount.

Few ratios to understand for long term investment

Days sales outstanding (DSO)

This ratio helps in understanding how quick any firm can collect its revenue after a sale has been made. The lower DSO states that the firm takes few days to collect its revenue which is a good sign, the higher DSO on the other hand states that the firm is lagging in collecting its revenue. The DSO for Infosys is given below.

Particulars	2013-14	2012-13	2011-12	2010-11	2009-2010
DSO (days)	60	63	63	61	56

As we can see from the above table that DSO in 2009-2010 was a good number and it slowly increased and maintained the same which is not good for Infosys as it means that Infosys is unable to maintain lower DSO which in turn hampers its cash flows.

Current Ratio

Current ratio measures the current liquidity of the firm. It helps investors in understanding whether the firm is capable of meeting its short term liabilities. The formula for current ratio is given as

Current Ratio = Current Assets / Current Liabilities

Current assets include cash, marketable securities, account receivables, inventory, deferred tax assets etc. Current liabilities include short term loan payment, account payables deferred tax liabilities etc. For current Ratio to be more than 1, the Current assets must be more than current liabilities. The following table shows the current ratio for Infosys:

Particulars	2013-14	2012-13	2011-12	2010-11	2009-2010
Current ratio	3.83	3.82	4.72	5.05	4.46

The Current Ratio was at its best for the firm during 2010-2011.  The current ratio kept decreasing from the year 2012 to 2014 which is a negative sign. This implies that Current Liabilities are more than Current Assets and there is a decrease in working capital which is given as the difference between Current Assets and Current Liabilities.

Earnings per Share (EPS)

This ratio speaks about how much every common share holder earns per every share he holds. The more the EPS the better the value of firm. The formula for EPS is given as:

EPS = (Net Income – Preferred Dividends) / Weighed Average Outstanding Shares Available

In case of Infosys, the number of shares in the open market has increased and this will lower the EPS as increase in number of outstanding shares (denominator) in the EPS formula will bring down the value of the EPS.

Apart from fundamental analysis, rupee appreciation also plays a vital role in determining the profits for the firm. As and when the rupee depreciates to dollar, the Firm has more profits and vice versa.

As previously mentioned, the firm depends more on North America for its revenue purpose. Therefore the economic and political factors of North America have to be good so that the Infosys performance can increase and remain positive.

Conclusion

As far as I am concerned, I would say that it would be wise to do a thorough fundamental analysis before going for a long term investment in Infosys. A part of fundamental analysis and other analysis is given above. Mere increase of shares and decrease in the value of share may not increase the value of the firm as the quarter results are weak along with the fundamentals.

Vishal Sikka (CEO & MD) of Infosys will have a tough time ahead in alleviating the above mentioned problems. He was with SAP as one of the board director earlier which is a Software Development Company and Infosys being a Software Services Company is a challenge for Dr. Sikka as his prior experience is not into software service.

Infosys sits on a pile of cash and the debt in the capital structure of the firm is very low which is an advantage to the Firm.

Overall, any Investor should be very careful in investing in Infosys right away. They shouldn't invest  just on the basis of bonus shares announcement. A complete fundamental analysis should be done before taking any decision.

Why GE opted for Buyback of shares

I just happened to read through an article on GE on buyback of its shares. I thought to put my thoughts as to why this decision has been made.

One of the biggest decisions which any firm has to make is to consider the option of buying back the firm's shares. The following points make firms to opt for a buyback:

1. If the Firm is sitting on pile of cash.

2. To make their stock look attractive.

3. Change the structure of their capital (Debt/Equity).

4. To project a better financial ratios.

Let us consider GE in this case. GE has to buyback its shares due to the poor performance of its subsidiary firm GE Capital. GE Capital suffered due to recession which took place in the year 2008. It invested in many alternative investments. One such investment is real estate. The credit markets froze due to the falling prices of real estate and GE couldn't fund its day to day operations. The result of this is the drop in day to day activities, layoffs, profit margins etc. Due to the recession, the financials of GE have taken a hit and eventually led to drop in share price.

How does buyback help GE

·         Buyback of shares increases the key ratios of GE. Earnings per share of GE will increase since the number of outstanding shares in the markets goes down which in turn increase the value of EPS.

EPS = (Net Income – Preferred Dividends) / Outstanding number of shares

·         Return on Assets (ROA) will also increase since cash is considered to be an asset and GE has to pay existing shareholders with the cash to complete the buyback.

ROA = Net Income / Average total assets

·         P/E ratio is considered to be attractive when it is low. Due to the buyback, the EPS will increase which in turn decreases the P/E ratio of GE.

P/E = Market Value per Share / Earnings per Share (EPS)

·         The existing shareholders who are holding shares will have an advantage since GE will buyback the shares at a premium and shareholders who are in favor of buyback will earn good amount of profits.

·         Any long term investor would always use the fundamental analysis as his/her weapon while choosing a long term investment and the fundamental analysis includes these key ratios as well.

·         Once the investors look into these financials they feel all the more attractive towards this stock and keep buying the shares which have now increased in value as the buyback has happened. Once GE gains back the investor confidence again, they can go for a an FPO (Optional) and raise money so that they can payback their debts which in turn increases its working capital efficiency.

·         Since the economic conditions were poor for a period of time after recession , the stock value of GE is undervalued. Buyback will help the stock price to rise and remain competitive.

One important thing to be considered after buyback is the share price. Initially the share price may increase but gradually it might decrease as well. Investors should analyse carefully and then proceed with the investment.

Overall, GE remains a good stock pick for the investors due to varied reasons such as its brand value, diversity in business, long standing history of the firm etc. My opinion for a profitable long term investment for any investor is to include GE in his portfolio of stocks.