Back to basics

The profit & loss account

Introduction

If you own shares, you'll remember that the company sends you a booklet called an annual report just before the annual general meeting. Most of the time, all you've done is admired the glossy pictures before adding it to the pile of newspapers for the raddiwala.

That's a pity, because a company's annual report can be a great source of information, helping you to decide whether to stay invested in the company. At the very least, it'll help you ask some tough questions to the management at the AGM.

We know the problem. You'll be thinking that's a lot of unreadable stuff! Not to worry, accountants are in business by making it difficult for ordinary people to understand accounts! All of us can learn to read accounts. We'll show you how.

The profit & loss account

At the heart of the annual report is the Profit & Loss Account. Accountants call it the P&L account to show familiarity, as well as to make it difficult for ordinary people to understand what they're talking about.

No company can exist for long by continuously making losses, and the P&L account shows the extent of profit or loss made by the company in a particular year. To illustrate, let's take the Reliance Industries annual report for 1998-99.

	1998-99		1997-98
	Rs.	Rs.	Rs.	Rs.
INCOME
Sales		14,553.26		13,403.78
Other Income		607.55		335.60
Variation in Stock		(152.43)		368.28
		15,008.38		14,107.66
EXPENDITURE
Purchases		190.32		14.19
Manufacturing and Other Expenses		11,500.52		11,206.93
Interest		728.81		503.55
Depreciation	1,776.66		1,460.27

Less : Transfered from General Reserve (Refer Note 3, Schedule 'O'){	921.62	855.04	792.95	667.32
		13,274.69		12,391.99
Profit Before the year		1,733.69		1,715.67
Provision for the year		30.00		63.00
Profit for the year		1,703.69		1,652.67
Add:Taxation for the earlier years		-		(85.67)
Balance brought forward from last year		1,047.89		662.79
Investment Allowance(utilised)		-		-
Reserve written back		-		36.00
Amount available for Appropriation		2,751.58		2,265.79
APPROPRIATIONS
Debenture Redemption Reserve	204.50		64.47
General Reserve	1000.0		752.65
Interim Dividend	23.39		10.33
Proposed Dividend	350.16		326.81
Tax on Dividend	40.86	1,618.91	63.64	1,217.90
Balance carried to Balance Sheet		1,132.67		1,047.89
Significant Accounting Policies
Notes on Accounts

You'll notice there are two main heads - income and expenditure. Simply put, the difference between the two is the profit (if income exceeds expenditure) or loss (if expenditure exceeds income). And losses, as you know, are bad.

Income

The total income is broken down into several heads-sales, other income, and variation in stock. Obviously, a company's sales will be its main source of income, so that item doesn't need much explaining. A source of confusion can be the fact that sales are sometimes called gross sales and at other times net sales. The difference is the amount of excise duty paid, and net sales is merely gross sales less excise duty. Net sales is a better indicator of how much the company is selling, because the excise duty goes to the government. Clearly, higher sales help the company earn higher profits.

"Other income" is accountantspeak for all those items of income which do not relate directly to the company's sales. This could include dividends and interest received by the company from its investments, the profit on sale of investments or assets, sale of scrap and other such items. Some companies put service income, like money earned by repairing or servicing, in this category. Basically, the thing to remember is that other income is very often, but not necessarily, income from activities distinct from the company's main activity. Sometimes such other income is one-off in nature, such as the profit from selling assets. So if you want to predict the company's future income, you'll have to leave out this kind of one-off income.

The third item, variation in stock, reflects the fact that a company always carries some inventory, which is nothing but unsold stock on a particular date. The company has already incurred some expenditure in producing this inventory, which is reflected in the expenses part of the P&L account. So the value of the closing stock should also be included to give the correct picture of the profit. However, from this closing stock the value of the stock at the beginning of the accounting period must be subtracted, since that was included as closing stock during the previous accounting period. That sounds complicated, but just remember that the variation in stock is actually nothing but closing stock less opening stock of finished goods and stocks in process. Why not raw material stocks? Raw material stocks are not included here because there is an item "raw material consumption" in the expenditure section of the P&L account.

Expenditure

The expenditure part of the P&L obviously has purchases and manufacturing expenses. In fact, all the costs that go into making the things the company sells. But that's not all. Interest costs incurred on the company's debts are also included here. Further, there's an item known as depreciation, which is nothing but a notional estimate of the wear and tear of the equipment used by the company. The logic is that a company needs to set aside a sum annually so that it can buy new machinery when it is needed. Clearly, keeping costs in check will add to the bottomline.

You'll notice that there's something known as schedules against the items in the P&L account. These are nothing but more detailed break-ups of these items. For instance, in the RIL P&L account, schedule L gives details of all the manufacturing expenses, such as salaries and wages, sales and distribution expenses, expenses on power, fuel, and administrative expenses like rent, insurance, etc.

Profit and EPS

Deducting expenditure from income gives the profit before tax. When the amount set aside by the company for tax purposes is deducted, we get the all-important net profit figure. Adding the balance brought forward in the account last year, we get the amount available for appropriation, which is nothing but the way the profit is divided. One chunk is paid to equity shareholders as dividend, one part goes towards paying dividend on preference shares, while the rest goes to statutorily required reserves, such as the reserve for redeeming debentures, and to the general reserve, which bolsters the company's net worth, or the amount of shareholder's funds.

A last word about EPS, which is earnings per share. This is a figure analysts love to talk about. EPS is calculated by dividing net profit by the number of shares allotted by the company. It shows how much each share of the company has earned during the year.

Also important is to check out the trends, by comparing last year's figures with those of the current year. Trends are important because they show the way the company is going. For instance, a company may still be earning profits, but the amount gets smaller and smaller each year. Nobody in his right mind would invest in such a company.

That wraps up the basics of the P&L account. Investors can use this information not only to find a company's earnings, but also how it has arrived at these earnings. Did sales increase? Were expenses kept in check? Was interest expenditure too high? The answers to these questions will be provided by reading the P&L account.

Graduating in Risk Premium

In case you have reached this vantage point after having understood the basics of 'risk premium', we offer you our hearty congratulations on having made such outstanding progress!

Now, picking up the thread from where we left off, investors get compensated only for the market risk that they bear. Market risk is the only risk that cannot be reduced through diversification in your portfolio (by including a set of stocks from different businesses), like business risk can.

However, the influence of the market varies for various stocks. Some stock movements are exaggerated compared with market movements while others are subdued.

We understood last time that the 'beta' of a stock measures this relative movement of a stock vis-?is the market. Hence, 'beta' measures the tendency of the stock to participate in the market movement.

Let's work this out using an example...

Hyper Ltd., Tracker Ltd. and Sober Ltd. are three stocks that trade in the stock market of Shareland. Sharex is the stock market index in Shareland. Hyper has a beta of 1.3 while Tracker has a beta of 1. On the other hand, Sober has a beta of 0.7.

First stop, what do these values mean?

Hyper's beta value of 1.3 indicates that it is far more sensitive to market movements than Tracker and Sober. In other words, if the market as measured by Sharex goes up by 10%, Hyper will go up by 13%. Tracker will go up as much as the market, i.e. 10%, while Sober gains a mere 7% in relation to the market.

Who commands the lower risk premium?

After having come so far in the lesson, we expect that you will flip this situation to its negative face and look at the situation when the stock market in Shareland drops by 10%.

In this case, Hyper drops the most (by 13%) as it has a higher beta of 1.3. Since Tracker has a beta of 1, it drops by 10%, the same as the market. On the other hand, Sober drops by a mere 7%.

A higher beta means higher risk and hence a stock with higher risk needs to command a higher 'risk premium'. And obviously, since Hyper reacts in a manner true to its name for every drop/gain in the market, it is the riskiest stock and should command the highest premium, followed by Tracker with Sober being the least risk option of the three.

Moving on to CAPM

So if the risk premium commanded by the stock market is x%, then the risk premium that investors should demand for a particular stock is beta times x%. CAPM states that the expected return on a stock is the sum of a `risk-free rate' and `stock beta times market risk premium'.

This, in essence, is the capital asset pricing model (CAPM). After all, why should anyone expect to earn more by investing in one stock as opposed to another? You need to be compensated for doing badly when times are bad. The stock that is wont to do badly just when you need money in trying times is a stock you should hate, and there had better be some redeeming virtue or else who would want to hold it?

How is beta calculated?

Oh, we are not going to give you some longwinded formula. After all these days, you do not need to know how a computer works to actually use one. So, we shall never trouble you with formulae, but just explain the concept.

An analyst calculating the beta of a stock obtains the historical returns of that stock over a period and then compares them using 'linear regression' to the returns on the index. It is just enough for most of us to know that linear regression is a statistical tool for estimating beta.

Some pertinent questions to ask at this stage

Q: Is the beta of a stock constant?

A: The beta of a stock can change over time as the stock's characteristics transform. For example, a stock moving from the B1 group to the A group sometime back would have changed the beta of the stock. After all, the underlying liquidity of the stock would have changed as A group stocks have this carry forward mechanism that attracts a whole host of speculators.

Q: Can a low beta stock be more volatile than a high beta stock?

A: Interestingly, a low beta stock could be more volatile than a high beta stock. Remember, the beta measures only the systemic risk or the influence of the market on the stock whereas a stock on its own might have a very high unsystemic risk because of the risk associated with the company's business.

Wrapping up today's spoils

The key insight of the capital asset pricing model is that higher expected returns go with the greater risk of doing badly in bad times.

Beta is a measure of a stock's tendency to move with the market. Stocks with high betas tend to do worse in market downturns than those with low betas.

Our advice: If your heart has a high beta level, invest in a stock that has a low beta!

Back to basics

The profit & loss account

Introduction

If you own shares, you'll remember that the company sends you a booklet called an annual report just before the annual general meeting. Most of the time, all you've done is admired the glossy pictures before adding it to the pile of newspapers for the raddiwala.

That's a pity, because a company's annual report can be a great source of information, helping you to decide whether to stay invested in the company. At the very least, it'll help you ask some tough questions to the management at the AGM.

We know the problem. You'll be thinking that's a lot of unreadable stuff! Not to worry, accountants are in business by making it difficult for ordinary people to understand accounts! All of us can learn to read accounts. We'll show you how.

The profit & loss account

At the heart of the annual report is the Profit & Loss Account. Accountants call it the P&L account to show familiarity, as well as to make it difficult for ordinary people to understand what they're talking about.

No company can exist for long by continuously making losses, and the P&L account shows the extent of profit or loss made by the company in a particular year. To illustrate, let's take the Reliance Industries annual report for 1998-99.

	1998-99		1997-98
	Rs.	Rs.	Rs.	Rs.
INCOME
Sales		14,553.26		13,403.78
Other Income		607.55		335.60
Variation in Stock		(152.43)		368.28
		15,008.38		14,107.66
EXPENDITURE
Purchases		190.32		14.19
Manufacturing and Other Expenses		11,500.52		11,206.93
Interest		728.81		503.55
Depreciation	1,776.66		1,460.27

Less : Transfered from General Reserve (Refer Note 3, Schedule 'O'){	921.62	855.04	792.95	667.32
		13,274.69		12,391.99
Profit Before the year		1,733.69		1,715.67
Provision for the year		30.00		63.00
Profit for the year		1,703.69		1,652.67
Add:Taxation for the earlier years		-		(85.67)
Balance brought forward from last year		1,047.89		662.79
Investment Allowance(utilised)		-		-
Reserve written back		-		36.00
Amount available for Appropriation		2,751.58		2,265.79
APPROPRIATIONS
Debenture Redemption Reserve	204.50		64.47
General Reserve	1000.0		752.65
Interim Dividend	23.39		10.33
Proposed Dividend	350.16		326.81
Tax on Dividend	40.86	1,618.91	63.64	1,217.90
Balance carried to Balance Sheet		1,132.67		1,047.89
Significant Accounting Policies
Notes on Accounts

You'll notice there are two main heads - income and expenditure. Simply put, the difference between the two is the profit (if income exceeds expenditure) or loss (if expenditure exceeds income). And losses, as you know, are bad.

Income

The total income is broken down into several heads-sales, other income, and variation in stock. Obviously, a company's sales will be its main source of income, so that item doesn't need much explaining. A source of confusion can be the fact that sales are sometimes called gross sales and at other times net sales. The difference is the amount of excise duty paid, and net sales is merely gross sales less excise duty. Net sales is a better indicator of how much the company is selling, because the excise duty goes to the government. Clearly, higher sales help the company earn higher profits.

"Other income" is accountantspeak for all those items of income which do not relate directly to the company's sales. This could include dividends and interest received by the company from its investments, the profit on sale of investments or assets, sale of scrap and other such items. Some companies put service income, like money earned by repairing or servicing, in this category. Basically, the thing to remember is that other income is very often, but not necessarily, income from activities distinct from the company's main activity. Sometimes such other income is one-off in nature, such as the profit from selling assets. So if you want to predict the company's future income, you'll have to leave out this kind of one-off income.

The third item, variation in stock, reflects the fact that a company always carries some inventory, which is nothing but unsold stock on a particular date. The company has already incurred some expenditure in producing this inventory, which is reflected in the expenses part of the P&L account. So the value of the closing stock should also be included to give the correct picture of the profit. However, from this closing stock the value of the stock at the beginning of the accounting period must be subtracted, since that was included as closing stock during the previous accounting period. That sounds complicated, but just remember that the variation in stock is actually nothing but closing stock less opening stock of finished goods and stocks in process. Why not raw material stocks? Raw material stocks are not included here because there is an item "raw material consumption" in the expenditure section of the P&L account.

Expenditure

The expenditure part of the P&L obviously has purchases and manufacturing expenses. In fact, all the costs that go into making the things the company sells. But that's not all. Interest costs incurred on the company's debts are also included here. Further, there's an item known as depreciation, which is nothing but a notional estimate of the wear and tear of the equipment used by the company. The logic is that a company needs to set aside a sum annually so that it can buy new machinery when it is needed. Clearly, keeping costs in check will add to the bottomline.

You'll notice that there's something known as schedules against the items in the P&L account. These are nothing but more detailed break-ups of these items. For instance, in the RIL P&L account, schedule L gives details of all the manufacturing expenses, such as salaries and wages, sales and distribution expenses, expenses on power, fuel, and administrative expenses like rent, insurance, etc.

Profit and EPS

Deducting expenditure from income gives the profit before tax. When the amount set aside by the company for tax purposes is deducted, we get the all-important net profit figure. Adding the balance brought forward in the account last year, we get the amount available for appropriation, which is nothing but the way the profit is divided. One chunk is paid to equity shareholders as dividend, one part goes towards paying dividend on preference shares, while the rest goes to statutorily required reserves, such as the reserve for redeeming debentures, and to the general reserve, which bolsters the company's net worth, or the amount of shareholder's funds.

A last word about EPS, which is earnings per share. This is a figure analysts love to talk about. EPS is calculated by dividing net profit by the number of shares allotted by the company. It shows how much each share of the company has earned during the year.

Also important is to check out the trends, by comparing last year's figures with those of the current year. Trends are important because they show the way the company is going. For instance, a company may still be earning profits, but the amount gets smaller and smaller each year. Nobody in his right mind would invest in such a company.

That wraps up the basics of the P&L account. Investors can use this information not only to find a company's earnings, but also how it has arrived at these earnings. Did sales increase? Were expenses kept in check? Was interest expenditure too high? The answers to these questions will be provided by reading the P&L account.

Chasing the elusive 'Risk Premium'

Welcome to the next leg of our 'Risk Premium' journey

Having come so far in the lesson, one would assume that you have understood that the risk premium demanded by equity investors on their investment is forward-looking, as it is based on the expectation of returns. You have also understood that risk premium increases with higher volatility of expected returns.

Hence, we saw our friend Mr Savvy Investor choose an investment option, based not just on expected returns but expected returns adjusted for the risk. So, take a deep breath and think back on what trait Mr Savvy Investor was displaying when he made the requisite calculations.

He was avoiding risk! He was unwilling to take on additional risk unless he was compensated for taking that risk.

Such risk avoiding behaviour is the cornerstone of rational investing. Textbooks state that a rational investor is risk averse, and that rational investors measure reward using expected return and risk calculated as variance.

Risks borne by an equities investor

Time to take a quick look at the broad classes of risks borne by an equity investor:

As you figured out while reading "Taming the risks" , the risk borne by equity investors can be classified as two types - systemic risk, which is market risk and unsystemic risk, which is risk borne specific to a business. We also discovered that unsystemic risk can be reduced by diversifying investments across a basket of stocks representing various businesses. However, systemic risk is something that we have to live with.

Can an investor expect compensation for bearing both market and business risks?

If your answer is yes, you probably are asking for a little too much. Remember that, as an equity investor, you can spread your investments across a basket of stocks to reduce your business risk to zero. In fact, there are extensive studies that show that even a portfolio with eight stocks reduces unsystemic risk to zero. Hence, the only risk that an equity investor can demand a premium for is the systemic or market risk.

Now that we know what type of risk you can demand compensation for, how do we go about measuring it? Simple, the risk premium for systemic risk needs to equal the risk premium for the market as a whole. After all systemic risk exists because of the pervasive influence of the market.

But just the risk premium for the market is not enough

What have we missed? Let's see... Assume that a new government came to power at the Centre and the Sensex went up by 8% in two days...

1. Would you think HLL, Infosys and HFCL all went up by 8% each?
   
   
2. If you think that they all went up by different percentages, then which one do you think went up the most?

We have all seen that every stock posts different gains for the same gain in the Sensex. Stocks like HLL do not rise as fast as the market nor do they drop as fast. Infosys on the other hand posts gains higher than the market. HFCL, we are all well aware, moves sharply higher whenever the market moves higher while falling more sharply than the market in the downswings.

In other words, the influence of the market forces is different on different stocks. Hence, we cannot just settle for the risk premium commanded by the market. We need to measure how the market affects a particular stock.

The 'beta' factor

'Beta' measures the factor of influence of the market on a particular stock. Financial expert William Sharpe worked out a method for doing just this (calculating the beta of a stock). Many of you would have come across the concept of 'capital asset pricing model' or CAPM.

CAPM makes a fundamental assumption that the historic volatility of stock prices will be mimicked in the future too.

Next time, we will unravel how CAPM and beta help us get a fix on this elusive risk premium. Until then, I leave you with a thought to ponder:

Do you think a high beta stock should have a higher risk premium or a lower risk premium?

What is right risk premium?

Risk is not always a bad thing

What is the second thing that strikes your mind when you hear the word 'equity' or 'stock'? (If 'risk' is the first thing that flashes across your mind, then you seem to have had an overdose of emphasis on risk in our recent school write-ups. Maybe it is time for you to learn more about how stocks offer great returns over the long run and the 'power of compounding'.)

If 'risk' is the second thing to take the dias, you are ready to take the next few steps in understanding this concept better. And just in case 'risk' was the last thing to chance upon your mind, we suggest that you start right at the beginning of these series.

What is equity risk premium?

Last time we understood that though risk is the chance of loss, it is equally a matter of choice. 'Equity risk premium' is the leveller that makes risky investment options attractive. Now it is time to put a finger on 'equity risk premium'.

We saw that Mr Savvy Investor settled for investing in the stock since he expected to make 13.4% extra returns over the 30% return on government bonds in three years. In other words, equity risk premium is forward looking.

If equity risk premium is forward looking and based on expectations, how do we know that we have settled for the right 'risk premium? Or how do we know that the 'risk premium' adequately compensates us in case the returns go against expectations?

A theoretically applicable method is to look at returns associated with all possible situations. Then assign probabilities to these possibilities and get a fix on the 'expected' return. In the end, the expected return needs to be compared with the risk-free return to evaluate if the 'risk premium' is adequate enough.

A little lost? Back to our good friend - Mr. Savvy Investor.

Our thought experiment

Small Cement Company (SCC), Efficient Cement Company (ECC) and Big Cement Company (BCC) are three cement companies.

SCC has small capacity and hence its earnings improve dramatically after cement prices cross a threshold price. ECC, on the other hand, has a very efficient process and hence its earnings improve sharply with any rise in cement prices. The biggest of them all, BCC, is not so sensitive to cement prices, thanks to its size. In other words, BCC's bottom line moves in a more sober manner to the changes in cement prices.

Time to make one simplistic assumption

Let us assume that the earnings of these companies are sensitive to only cement prices. Hence, cement prices determine the returns from investing in these stocks.

Mr. Savvy Investor needs to pick the best investment option from these three companies.

Luckily, a cement expert and a stock market analyst have made life for our friend a little simple.

The cement expert has assigned the following probabilities for the change in cement prices over last year. The stock market analyst has given his assessment of the expected returns from these three stocks for the respective changes in cement prices.

Event	Probability	Returns
		SCC	ECC	BCC
5% decline	20%	-5%	0%	5%
Flat	30%	+10%	+10%	+10%
5% increase	40%	+25%	+20%	+15%
10% increase	10%	+35%	+30%	+25%

Mr Savvy Investor had to make a wise choice with just these details.

He calculated the average returns that he expected to make for each company. He had the probabilities associated with each return. Hence, all he had to do was multiply each probability with the associated return and add all of them together. For example, the average return that one can expect on SCC worked out to:

20%*-5%+30%*10%+40%*25%+10%*35% = 15.5%. This way, he calculated the expected returns for these three companies as follows:

	SCC	ECC	BCC
Expected Returns	+15.5%	+14%	+12.5%

Do you think the choice was very easy for Mr Savvy Investor? After all, he just worked out that SCC has the highest expected returns.

Think again, for our wise investor has chosen BCC over the others.

To find out why, cast a glance upon the main table again. The returns on SCC can swing from -5% to 35%, an extremely volatile stock indeed, with returns moving in a range of 40% from -5% to 35%. On the other hand, ECC is little less volatile as its returns fluctuate within a band of 0% to 30% - a range of 30%.

Finally, BCC is found to be a relatively steady stock. The worst case return on BCC is found to be 5% although the best case return, at 25%, is less than the returns of the other two. Anyway, this is a comparatively small range of 20% fluctuation in return.

Factoring in volatility of return

Mr Savvy Investor made another smart back of the envelope calculation. He divided the expected returns for each of these stocks by the range of possible returns. Look at what he got from his crude calculation...

	SCC	ECC	BCC
Exp Returns/Range	0.3875	0.467	0.625

In other words, Mr. Savvy Investor calculated his expected returns for every unit range of return that the stock could swing. A neat approximation to what the statisticians will call 'deviation from the mean'. BCC turned to have the highest return for every unit of risk.

The answer became obvious to Mr. Savvy Investor- BCC was the best investment option.

Of course, he might discover that the risk premium built into the 12.5% return from BCC' investment is not a good enough premium. But that is a different story altogether.

A recap on this lesson

We will revisit these calculations later. It is time now to take stock of what we have learned about 'equity risk premium' so far:

• This premium is forward looking in nature, as it is based on 'expectation' of return.
• Expected returns could vary within a wide range. A higher range of return implies a higher gap between expected return and the actual return, thereby increasing the uncertainties associated with the return.
• We also understood that in case the range of returns from an investment in a stock is very large, then investing in the stock is more risky. However, this was a crude way of pinning the volatility of stock returns.
• After all the more likelihood of stock returns swinging from our expected returns, the more uncertain the actual returns we realise in the future. Look at our example, SCC returns are expected to be 15.5% but the eventual returns could swing any where from a -5% to 35% depending on how cement prices turn out.
• Statistically, the deviation from the expected return is a measure of the volatility of the stock returns.
• It is not enough to select the stock with the highest 'expected' return. It is important to select a stock that has a higher return per unit of risk.

Of course, this essentially explains the concept of 'equity risk premium'. The higher the volatility or uncertainty, the higher the risk premium sought by the investor.

Getting the 'risk premium' right - the next step

Now that we understand all these concepts, how do we get around the issue of obtaining a fix on this risk? After all, everybody invests based on expectations. How can we figure out today how much the returns will deviate from expectations in the future?

Academicians have worked on evolving methods that help us approximate and get a better fix on these future uncertainties. Next time, we will grapple with the issue of getting a fix on 'risk' and demanding the right 'risk premium'.

Calculated Risk

Only those who risk going too far can possibly find out how far one can go
- T.S.Eliot

'Investing is risky business'

We have all come across this statutory warning or have learnt it the hard way while investing in the stock market. Let us take a step back to understand what is 'risk'.

The word is commonly used to describe the chance of a loss.

Chance: the Webster Dictionary defines this word as 'something that happens unpredictably without discernible human intention or observable cause' In other words, risk in the financial context stands for the uncertainties associated with future cash flows.

We have learnt earlier how savings transform to 'Risk Capital'. We have taken a hard look at equity risks and figured out that 'Khel risky hai'.

But did you know that 'Risk' owes its origin to the Italian word risicare that literally means 'to dare'? Risk as a verb is used to imply 'taking the chance'. In other words, as Peter Bernstein observes in the introduction to his magnum opus 'Against the Gods',

'... risk is a choice rather than a fate. The actions we dare to take, which depend on how free we are to make choices, are what the story of risk is all about. And that story helps define what it means to be a human being...'

If 'risk' is all about choices, it is time to know how to factor this in our investment decisions.

Let us learn how these choices are made from the actions of Mr. Savvy Investor. Needless to say he is the smart guy who makes the smartest choices when it comes to investing.

Mr. Savvy Investor has Rs1,00,000 to invest. He has two investment options.

The first option is a government bond that pays an interest of 10% per annum for the next three years.

The second option is investing in a particular stock. A leading analyst expects this stock to go up by just 2% in the first year as the company is still expanding capacity. But he expects the stock to gain 28% in the next two years.

Mr. Savvy Investor fishes out his pocket calculator and gets down to business.

The bond option is fairly easy to calculate. His Rs1,00,000 investment would be worth Rs1,30,000 in three years. In other words, it would fetch him a return of 30% in three years.

He works out the returns for the second option.

His investment would be worth Rs1,02,000 at the end of the first year. A gain of 28% over the next two years means that his investment would be worth Rs1,30,560. Thanks to the 'power of compounding. his 2% gain in the first year will earn a return too. In the end, he would earn a 30.56% return in three years.

Two investment options with almost the same returns in three years. Which option does Mr. Savvy Investor choose?

Our Mr. Savvy Investor chooses to invest in the government bond.

It is easy to figure out why Mr. Savvy Investor has chosen the bond option.

Though investing in the stock meant marginally higher returns. There were lots of uncertainties. Remember, investment in the stock is based on expectations, expectations of a leading analyst, in this case. On the other hand, the government bond gives a fixed return with no question of a default.

What if the analyst got it all wrong? For all you know, a competitor might increase capacities and kill the market in the second year. Hence, the expected 28% appreciation might actually turn out to be a decline! As Murphy's law states 'If anything can go wrong, it will go wrong'.

Hence, Mr. Savvy Investor does not even bat an eyelid while deciding to invest in the government bond.

Let us now add a twist to the second investment option and see if it makes a difference to Mr. Savvy Investor's choice.

The leading analyst expects the stock to go up by 12% this year as the company has finished expanding its capacity six months before time. He also expects the stock to gain 28% in the next two years.

Mr. Savvy Investor does his calculations to figure out that his investment, in this case, would fetch a return of 43.4% in three years. A good 13.4% more than the government bond.

Like earlier, the uncertainties still remain. However, since Mr. Savvy Investor earns 43.4%, he can still take the chance. If the stock fails to go up by 28% in the next two years and instead goes up by just 17%, he will still make a return of 31%! In other words, the higher return provides a margin of safety.

Hence, the higher rate of return over the government bond for the same period makes Mr. Savvy Investor prefer the second option of investing in the stock.

What made him go for the second option?

The 13.4% extra return over the government bond. This 'extra return' that induces our Mr. Savvy Investor to choose the more uncertain investment option is called 'Risk Premium".

A financial textbook will tell us that

Risk premium is the 'reward for holding a risky investment rather than a risk-free investment.

The extra return that the stock market or a stock must provide over the risk-free rate of return to compensate for the market risk is called "Equity Risk Premium".

In case of Mr. Savvy Investor, the extra return of 13.4% over the risk-free 30% rate of return on the government bond defines his "equity risk premium"

How do you determine 'equity risk premium'? What is the right premium to settle for? What is 'Beta'? More of this next time as we brace ourselves to risk the stock market and brave the uncertainties.

As one great statistician wrote, "Humanity did not take control of society out of the realm of Divine Providence...to put it at the mercy of the laws of chance."

Taming the Risk

Welcome once again! Our preparation for the exciting journey into the adventurous world of equities has progressed to the next grade. In case you are joining us now, don?t lose heart. We will take you through a whirlwind tour of what we have learnt so far. For those of you who have been with us all through, it will be a good time to reflect on the key points. You will be better prepared to brave the adventure and emerge victorious.

We began by understanding the necessity to invest for growth, the necessity to beat inflation and retire wealthy. Our adventure began the moment we discovered that equities are lucrative. Not exactly! No adventure can be successfully undertaken before understanding the basics.

We figured out that the most important criteria to qualify for the journey is to be debt-free or, in simpler words, how much surplus we have after paying off all our obligations. We also understood a very important concept. Building of equity investments depends on two criteria:

1. Everybody can?t take the same level of excitement (Risk Profile)
2. Individual cash requirement (Liquidity Requirement)

Then came the party pooper?Risk. The outside chance of losing instead of gaining. In our attempt to understand risk, we classified risk into ?Controllable Risks? (also called ?Company Risk? or ?Diversifiable Risk?) and ?Beyond Control Risks? (also called ?Market Risk? or ?Undiversifiable Risk?). Wake up! We know that ?risk? will always exist. Let us learn to tame it.We use a clich?o reinforce an age-old truth: ?Don?t put all your eggs in one basket!? Spread it around so that if one basket were to drop, only a few of your eggs break! Equally important is to decide: ?In which basket do I put my eggs in?? We will take this up in our next leg of preparation. Remember, we hope to make soldiers out of you! Let us understand our monster better?Equity Risk. Try answering this question below. For the uninitiated, ?Long? stands for a bought position in stock while ?Short? stands for a sold position in a stock that is not owned.

Which of these options do you think is very risky? Which one is the least risky?
1. Long SAIL
2. Long SAIL & Long TISCO
3. Long SAIL & Long HLL
4. Long HLL, Long TISCO, Long ACC & Long Infosys

Let us look at all these four choices?
Choice #1-Long SAIL (our PSU steel company). I am exposed to company-specific risks (inefficient manufacturer, bureaucracy...). I am exposed to the steel cycle too (what if steel prices drop 5%?). To top it all I am exposed to the market risk (Vajpayee government?s fall takes the Sensex down 200 points. Want to know my SAIL price? It has hit the lower circuit!) Gosh! I am exposed to every conceivable risk.

Choice #2 - Long TISCO & Long SAIL. Tricky hey! Two biggest players in steel. As far as company specific risks go, TISCO is a better bet then SAIL. So I am better off. Steel sector downtrend affects both of them. However, since TISCO is a more efficient producer, he will do better than SAIL. So I am better off. However, as far as market risks go, both of them get affected anyway. So I am indifferent. Adding it all up, Choice #2 is definitely better than Choice #1.

We have learnt our first key learning. In choice #2 I had two stocks. I diversified. Voila! The risk reduced! So, diversification helps reduce risks!

Choice #3- Long SAIL & Long HLL. SAIL is a steel company whereas HLL manufactures soaps, detergents?products that human beings will always use come rain or shine! These two companies are in different sectors. If the economy or steel sector does badly, I lose out on only one half of my investment! HLL is a well managed company, so I am better off. Hey, I am much better off than my earlier choice. I have split my risks between two unrelated companies and sectors. What about market risk? SAIL has a lot of sympathy with market movement whereas HLL is very stable (People can?t stop taking a bath just because the Sensex has been down for six months! Whereas people will stop buying cars and car companies will stop manufacturing and hence, steel companies will not be able to sell their steel!!)

Choice #3 is excellent!

We have learnt our next key learning: Equity risk is not additive!

SAIL will have a certain risk on its own while HLL will have another one. But if we have the two of them together, then the risk of this basket will not be risk of SAIL plus risk of HLL. Remember, if SAIL is going down, HLL will not be as money flows to the safe stocks. Similarly, when the going is good, SAIL will outperform HLL.

Choice #4 How all of us would give our right hand to own it! All these four stocks are leaders in their sectors. The sectors almost cover the entire spectrum of the market. At least two of them will be doing well. Any guesses on where it stands on our risk spectrum? Obviously, it is our first choice as it is the least risky.

Another lesson: More widespread the selection of stocks, the better diversified and less risky a portfolio becomes. As the number of stocks increase, risk reduces.

All these instances of diversification were able to bring the ?diversifiable risk? under leash. However, there is another kind of diversification that can take care of the more crazy ?market risk?! A combination of long and short positions!!

Long HLL and Short SAIL. What have I achieved?
Let us look at company risks. Since, I hold HLL I own the company risk whereas if SAIL goes bust because of a company-specific risk, I gain because I have already sold it. With respect to market risks, if the market goes down, SAIL goes down more than HLL so I don?t lose money at all! In short, by using this combination I have only taken company-specific risk. A risk that I understand and can control.

These kind of combinations of long and short positions are used to mitigate market risks. Even the uncontrollable animal can be tamed! Market men call this ?Hedging?. ?Futures & Options?, which we will discuss later, facilitate this better.

Now we know how diversification helps reduce risks. Did anyone bother to ask: ?What about returns?? Well, the clever ones among you would have figured out that by limiting our downside, we have parted with a bit of the upside! So there is a trade-off. Achieving the right balance between risks and returns is the key. Laws of nature apply here too??Strike the right balance?. We will try to take up optimisation or maximising returns for a unit of risk very soon.

To play is always Risky

While reading through the past learning pieces, did you ever say to yourself: ?Such huge returns? Too good to be true. There must be a catch somewhere.? Or did Nagesh?s father?s apprehensions regarding market volatility and concerns over companies faring badly unsettle you? Did our reference to equity risk, ?no free lunch? and risk profile leave questions unanswered? We sure hope it did, because understanding risks associated with equities and learning how to manage them is the key to achieving higher returns from equities. Remember, the most important features of a fast car are the brakes and the steering wheel?not the accelerator! We begin our own humble attempt to understand this monster that can gobble up all our hard-earned returns!

Why have equity prices fallen in the past?

* Whenever governments have fallen; political instability (Top-of-the-mind recall)
* Inflation hitting double digits; rupee falling; interest rate hikes (the knowledgeable will tell you these are broad economic parameters that affect all businesses)
* A lot of people will tell you that wars have spooked the market?Gulf War, Kargil crisis, etc (country and lives are at stake.).
* Scams!! (Human greed knows no bounds).
* Bad management interested in making a quick buck themselves
* Company?s products bombed (Bad luck, bad strategy or bad marketing?).
* Lakshmi Machine Works suffers as textile mills are not doing well (a case of a specific sector going bad that wipes out even the best of companies).
* A chemical company?s plant caught fire destroying it completely (God save us!)
* A brilliant product but the company?s borrowings strangled the product before it saw the light of the day (Debt leads to death!)

So many of them, you ask? Let us see if we can classify them into broad categories. If you look at these reasons in detail, you realise that there are some factors that are within the company?s control or specific to the company?s business (bad management, products bombing, sector downslide, fire, borrowings?). The rest of the factors (politics, macroeconomic issues and wars) affect the market in general.

OK, we seem to have got two watertight classifications for equity risk. One affects specific companies and sectors. Textbooks have various names for it??diversifiable risk?, ?unsystemic risk?, ?business risk?, ?company risk? and so on. The other set of risk affects the entire market??undiversifiable risk?, systemic risk?, ?market risk?.....

The amazing power of classification! Suddenly, our big list of risks looks manageable. We just need to understand which basket they belong to! To get the classification right, let us delve a little deeper into the two groups. We will take up the ways and means of tackling these risks in our next session (lest we suffer from overload).

Company risk: a closer look
Though company risk is specific to the company, some risk factors that affect the business are within the control of the company. Corporate India is replete with instances of how a company could have controlled its future better.

Real Value?s (the ?Ceasefire? company) ill-conceived foray into ?vacuumisers? is an example of strategy going haywire. There are hazar Indian promoters who have siphoned money from their listed companies?examples of bad management. Core Healthcare (earlier Core Parenterals) is another classic example of a company that had the right product but, in its urge to build mega plants, it borrowed beyond its means before creating a market?the rest is history (the company got into a debt trap, and the product became a commodity).

All these risks can be avoided if proper homework is done to understand businesses and make a future looking call on their businesses. Only stock-picking skills can see you through this maze of risks. Now you know why good research analysts are so sought after!

The other sets of risks that are business specific are beyond the control of the company. What can Madras Cements do if the cement market suddenly slumps as there is too much new capacity with no matching demand! What can TNPL do if demand for newsprint falls as more and more people take to reading newspapers on the Internet! (Not now! But it can happen 10 years down the line) What can Tisco do if Posco dumps a million tons of steel in the country (not literally!)!

Of course there is something that these companies can do to rework their strategies, but it is time consuming. And you know our stock markets! The prices will get hammered with the first waft of bad news. In any case, if one were to diversify one?s holdings across various sectors and companies, the risks can get minimised to a certain extent. Risk diversification is another useful concept to understand, which we will take up next time.

Market risk
Company risk is still easy to contend with, but what do we do about market risks? Out of the number of factors affecting markets, our experience tells us that market declines under many of these factors are temporary and provide excellent buying opportunities for the patient investor who thinks and buys good companies (We love this kind of an investor or company)

Market risk is a different animal altogether. Diversification does not help as all stocks get affected by these factors. But fret not, the native ingenuity of mankind has found solutions to this problem too, in the form of ?Futures? & ?Options?.

We will be writing soon about the mechanisms behind such high-sounding terms and how you can use them (whenever they start here!)