Jul 05

Diversification

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Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio of several stocks. When this is the case, a portion of an individual stock’s risk can be eliminated, i.e. diversified away. This principle is called as Diversification and it is possibly the best way to reduce the risk in a portfolio.

A good portfolio cannot be formed by investing only in one type of security or sector, but by diversifying across various avenues. Diversification largely means investing in a variety of assets instead of just one type of asset. Due to this, potential of losses gets reduced because every instrument or industry would react differently to the same event. Although it does not guarantee against loss, diversification is the most important component of achieving long-term financial goals.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

Consider holding two stocks that have the same expected returns, instead of one stock. Because stock returns will not be perfectly correlated with each other, it is unlikely that both stocks will experience extreme movements (positive or negative) simultaneously, effectively reducing volatility of the overall portfolio. As long as assets do not move in lock step with one another (are less than perfectly positively correlated), overall volatility can be reduced, without lowering expected returns, by spreading the same amount of money across the multiple assets.

Imperfect correlation is the key reason why diversification reduces portfolio risk as measured by the portfolio standard deviation. This concept of diversification is one of the main tenets of modern portfolio theory – volatility is reduced through the addition of more assets to a portfolio.

Diversification, by putting stocks of various sectors that reflect the economy, is used to cancel out stock noise which is essentially the individual stock fluctuations and to reduce investor’s risks. Diversification is a strategy in which investor’s money is not invested in one place rather it is invested in different securities. It is assumed that if one category fails the loss can be made good by return from other categories.

Below mentioned are the few types of diversification:

  1. Diversification by asset class: A group of securities that show similar characteristics and behave similarly in the marketplace is called an asset class. The three main asset classes are stocks, fixed-income (bonds) and cash equivalents (money market instruments). Real estate and commodities such as gold are also considered as asset classes. A well-diversified portfolio invested across various asset classes can be an ideal strategy to participate in the top performing assets. e.g., Gold prices are traditionally inversely correlated to stock prices. So, gold can help minimize losses in a portfolio that includes stocks.
  2. Diversification by sector: A sector is one of a few general segments in the economy within which, a large group of companies can be categorized. To give an example: the financial services sector includes banking, insurance, NBFC, etc. An investor can invest across these broad sectors in order to minimize sector-specific risks. e.g., a spike in crude oil prices may boost prices of exploration & refinery sector stocks but aviation sector stocks may fall in reaction.
  3. Diversification by market capitalization: Mid and small-capitalization stocks have the potential to deliver higher returns than the Large-cap stocks, but they tend to be volatile in nature, which means, if the market goes down, small-cap stocks would lose maximum value followed by mid-cap stocks. On the other hand, large-cap companies provide support and stability to a portfolio as they may reduce risk in a downturn. An investor can reduce the risks faced by the mid and small-cap segment by diversifying investments into large-cap cap companies.

In this way, investors should develop a diversified portfolio that helps them limit downside risks while participating in the growth of asset classes or sectors or industries that are expected to do well. The portfolio should also be rebalanced from time to time taking into consideration the economic, business and/or policy environment. The latter two aspects are especially influential for India because our’s is still a developing nation on the path of growth. The opportunity to participate in India’s growth exists for us all but a simple tool like diversification can make our journey safer.

May 29

Insurance in India

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India’s rapid rate of economic growth over the past decade has been one of the most significant developments in the global economy. This growth has its roots in the introduction of economic liberalization in the early 1990s, which has allowed India to exploit its economic potential and raise the population’s standard of living.

Insurance has played very important role in this growth process. Life insurance, health insurance and pension systems are fundamental to protecting individuals against the hazards of life; and India, as the second most populous nation in the world, offers huge potential for that type of cover.

The story of insurance is probably as old as the story of mankind. The same instinct that prompts modern businessmen today to secure themselves against loss and disaster existed in primitive men also. They too sought to avert the evil consequences of fire, flood & loss of life and were willing to make some sort of sacrifice in order to achieve security. Though the concept of insurance is largely a development of the recent past, particularly after the industrial era – past few centuries – yet its beginnings date back almost 6000 years.

History of Insurance

In India, insurance has a deep-rooted history. It finds mention in the writings of Manu (Manusmrithi), Yagnavalkya (Dharmasastra) and Kautilya (Arthasastra). The writings talk in terms of pooling of resources that could be re-distributed in times of calamities such as fire, floods, epidemics and famine. This was probably a pre-cursor to modern day insurance. Ancient Indian history has preserved the earliest traces of insurance in the form of marine trade loans and carriers’ contracts. Insurance in India has evolved over time heavily drawing from other countries, England in particular.

History of Insurance in India can be broadly bifurcated into three eras: a) Pre-Nationalization b) Nationalization and c) Post-Nationalization.

Pre-Nationalization

The business of life insurance in India in its existing form started in the year 1818 with the establishment of the Oriental Life Insurance Company in Calcutta. This Company however failed in 1834. In 1829, the Madras Equitable had begun transacting life insurance business in the Madras Presidency. All the insurance companies established during that period were brought up with the purpose of looking after the needs of European community and Indian natives were not being insured by these companies. However, later these companies started insuring Indian lives; but Indian lives were being treated as sub-standard lives and heavy extra premiums were being charged on them.

1870 saw the enactment of the British Insurance Act and in the last three decades of the 19th century, the Bombay Mutual (1871), Oriental (1874) and Empire of India (1897) were started in the Bombay Residency. Bombay Mutual Life Assurance Society heralded the birth of first Indian life insurance company and covered Indian lives at normal rates. Starting as Indian enterprise with highly patriotic motives, insurance companies came into existence to carry the message of insurance and social security through insurance to various sectors of society. This era, however, was dominated by foreign insurance offices which did good business in India, namely Albert Life Assurance, Royal Insurance, Liverpool and London Globe Insurance and the Indian offices were up for hard competition from the foreign companies.

Prior to 1912 India had no legislation to regulate insurance business. In the year 1912, the Indian Life Assurance Companies Act, 1912 and the Provident Fund Act were passed. The Indian Life Assurance Companies Act, 1912 made it necessary that the premium rate tables and periodical valuations of companies should be certified by an actuary. But the Act discriminated between foreign and Indian companies on many accounts, putting the Indian companies at a disadvantage.

In 1928, the Indian Insurance Companies Act was enacted to enable the Government to collect statistical information about both life and non-life business transacted in India by Indian and foreign insurers including provident insurance societies. In 1938, with a view to protecting the interest of the Insurance public, the earlier legislation was consolidated and amended by the Insurance Act, 1938 with comprehensive provisions for effective control over the activities of insurers.

The demand for nationalization of life insurance industry was made repeatedly in the past but it gathered momentum in 1944 when a bill to amend the Life Insurance Act 1938 was introduced in the Legislative Assembly. There were large number of insurance companies and the level of competition was high. There were also allegations of unfair trade practices. The Government of India, therefore, decided to nationalize insurance business.

Nationalization

However, it was much later on the 19th of January, 1956, that life insurance in India was nationalized. About 154 Indian insurance companies, 16 non-Indian companies and 75 provident funds were operating in India at the time of nationalization. The Parliament of India passed the Life Insurance Corporation Act on the 19th of June 1956, and the Life Insurance Corporation of India was created on 1st September, 1956, with the objective of spreading life insurance much more widely and in particular to the rural areas with a view to reach all insurable persons in the country, providing them adequate financial cover at a reasonable cost.

In 1972, the General Insurance Business (Nationalization) Act was passed by the Indian Parliament, and consequently, general insurance business was nationalized with effect from 1st January, 1973. 107 insurers were amalgamated and grouped into four companies, namely National Insurance Company Ltd., the New India Assurance Company Ltd., the Oriental Insurance Company Ltd and the United India Insurance Company Ltd. The General Insurance Corporation of India was incorporated as a company in 1971 and it commence business on January 1st 1973.

Since 1956, with the nationalization of insurance industry, the LIC held the monopoly in India’s life insurance sector. GIC, with its four subsidiaries, enjoyed the monopoly for general insurance business. In spite of all the growth, nearly 70% of Indian populations are without Life insurance cover and the Health insurance. This is an indicator that growth potential for the insurance sector is immense in India.

From 1991 onwards, the Indian Government introduced various reforms in the financial sector paving the way for the liberalization of the Indian economy and against the background of these Economic Reforms insurance sector was also decided to be opened up. For this purpose Malhotra Committee was formed during 1993 which submitted its report in 1994.

Post-Nationalization

Following the recommendations of the Malhotra Committee report, in 1999, the Insurance Regulatory and Development Authority (IRDA) was constituted as an autonomous body to regulate and develop the insurance industry. The IRDA was incorporated as a statutory body in April, 2000. The IRDA opened up the market in August 2000 with the invitation for application for registrations. Foreign companies were allowed ownership of up to 26%.

Today India insurance is a flourishing industry, with several national and international players competing and growing at rapid rates. There are 24 general insurance companies and 24 life insurance companies apart from one national re-insurer (GIC) are operating in the country.

Indian insurance companies offer a comprehensive range of insurance plans and the most common types include: term life policies, endowment policies, joint life policies, whole life policies, loan cover term assurance policies, unit-linked insurance plans, group insurance policies, pension plans, and annuities. General insurance plans are also available to cover motor insurance, home insurance, travel insurance and health insurance.

With such a large population and the untapped market area of this population Insurance happens to be a very big opportunity in India. Today it stands as a business growing at the rate of 15-20% annually. Together with banking services, insurance services add about 7% to the country’s GDP. At present, India stands 12th among the top global markets for life insurance.

The Road Ahead

The market size> of Indian life insurance industry is expected to touch US$ 111.9 billion in 2015 from US$ 66.5 billion in 2011, at a compounded annual growth rate (CAGR) of 14.1%, according to a report by BRIC data. The report estimates that India would be the third-largest market for life insurance in the world by 2015. Also, the number of policies sold is expected to increase to 85.21 million in 2015 from 53.23 million in 2010.

By nature of its business, insurance is closely related to saving and investing. Life insurance, funded pension systems and non-life insurance, will accumulate huge amounts of capital over time which can be invested productively in the economy. In developed countries (re)insurers often own more than 25% of the capital markets. The mutual dependence of insurance and capital markets can play a powerful role in channeling funds and investment expertise to support the development of the Indian economy.

Apr 11

Buying Back the Shares

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SHARE BUYBACK
Share buyback means a company buying back its shares from shareholders other than promoters. Company does it to increase the shares’ prices or delist, and this is done by either buying in the stock market directly, or asking shareholders to tender their shares.

A buyback offer is when a company buys some of its shares from its shareholders and extinguishes them. This is usually done from shareholders other than the promoters themselves, and is most often a testament from the management and promoters on the strength of the company, and their commitment to increase the returns for the shareholders. Market experts say it usually shows the confidence of promoters in the future of the company.

THE RATIONALE BEHIND SHARE BUYBACK
There are a number of reasons companies go for buybacks. The intentions could be to reward investors, improve financial ratios (such as price to earnings, return on assets and return on equity), increase promoter holding, reduce public float and check the falling stock price, reduce volatility and build investor confidence.

The following are the 6 main reasons why company offers share buyback:

  1. To stop the fall in stock price.
  2. In some situation company may want to bring down the public holding and increase promoters holding.
  3. If the company sees there is no better opportunity to deploy its cash reserves then it may decide to buy back its shares.
  4. The buyback may improve companies return ratios. If they reduce the total number of outstanding shares then the EPS (Earnings per Share) increases because EPS is PAT (Profit after Tax) divided by total outstanding shares. If the EPS increases then the P/E multiple decreases, and when P/E decreases, the share price increases to bring the P/E back to the higher levels. Other ratios like Return on Equity and Return on Networth also improve due to this.
  5. When a company thinks its share price is undervalued.
  6. In case of eventual delisting, some companies, especially foreign owned companies get into buybacks because they want to eventually delist from the Indian stock exchange. Usually, they don’t buy their entire outstanding shares at one go, but conduct these buybacks over a period of time and buy in tranches of 5% or 10%.

MODES OF BUYBACK
First of all a buyback is proposed in general meeting of the company which is then voted on and approved by the board of directors. Then they announce the buyback in a newspaper with all the details. There are two types of common buyback routes companies take, open market purchase and tender offer, i.e. one is done through open market purchase from the stock exchanges, and the second is done through a tender form.

  •  When a company carries out buy back from the open market through stock exchange, there is nothing that you have to do except hope for a probable gain in stock’s market price. Company decides to acquire the certaisn number of shares to be bought back and fixes a price cap and can buy for any price up to that.
  • When company makes an offer to buy shares through the tender route, it has to declare the number of shares and the specific price, at which shares have to be bought back directly from shareholders. Company sends a tender form to all its shareholders with instructions on how to fill the form and where they can mail or drop the form. This route ensures all shareholders are treated equally, however small they are.

Most companies prefer the open market route. Out of 19 buybacks offers received in 2011, 14 were made through open market mode and 5 were made through tender offer mode. The biggest difference between the two is that the price in the tender route is fixed.

CAN INVESTORS GET SOMETHING BENEFICIAL OUT OF IT?
A buyback usually improves the confidence of investors in the company because it sends signal to the market that the company believes the stock is trading below its intrinsic value and therefore its stock price rises.

However, past data reveal the stock can move in either direction after the buyback announcement, though it helps stocks in most cases.
Below mentioned are the few points, in what ways an investor can be benefitted from the buyback of shares:

  1. Buy back at good premium may increase the stock price in share market.
  2. As buy back of shares reduces outstanding shares, the EPS (EPS is calculated by dividing net profit by outstanding shares) may look good.
  3. The ROA (Return on Asset) and ROE (Return on Equity) may improve by fall in outstanding shares and assets (in this scenario, excess cash).

Generally shares react positively to such announcements because buyback reduces the number of shares outstanding, which increases investors’ claims on dividends and earnings of the company and as these claims increases, so do stock prices.

Hereunder are a few instances of buyback announcement and its impact on the market prices:

  • When this year in January, SEBI approved changes in rules to allow public sector units (PSUs) to buyback shares, as a result, shares of few PSUs soared 30-50% in the first 5 trading sessions.
  • On January 20th, Reliance Industries Limited approved buyback of up to 120 million shares at a price not exceeding Rs. 870 per share from open market. The stock has risen 4% since despite the fact that company had reported poor numbers for the 3rd quarter. It was at Rs. 830 at the commencement of the buyback on February 1st.
  • But the case is always not the same, Indiabulls Real Estate started moving southwards after the buyback announcement. The company announced a buyback on December 15th 2011, after which the stock fell 3% to Rs. 48.25 till 7 January 2012.

The price trend depends on various factors such as the market situation, the mode of the offer, i.e. tender or market purchase, the size of the offer, the difference between the offer price and the market price of the stock and the market’s confidence in the management’s intention to carry out the offer. The movement of a stock after the buyback announcement depends on valuations and the result can differ from company to company.

THINKING OF PARTICIPATING IN BUYBACK?
If you plan to invest in any such company which is going to buyback its shares, there are some guidelines and the few words of caution to be followed:

  • You should not buy shares just because the company is working out a buyback plan. In some scarce cases, buybacks are announced to trigger certain favourable movements in stock price.
  • It is important to consider the size of the buyback, buyback price and the duration of the offer, because if the buyback size is too small compared with the overall market capitalization of the company, the impact on the stock could be very small.
  • Equally important to know what buyback route the company will follow, because if they will buyback the shares from the stock market, then the share buyback price is irrelevant to you.
  • If the company is buying back from the shareholders then you have to look at offer size of the buyback, how much time is left for the buyback to take place, and what is the difference between the current market price and the offer price.
  • Generally, companies only buyback a certain percentage of outstanding shares from the public and to know this fact is really important; because a few people who are not familiar with the process end up buying shares with the hope of sure-shot profit and later stuck-up with the remaining shares as only a part of their holding has been bought back.

Whatever decision you take largely depends on these variables, and they can be entirely different with every single case. Generalization of these variables in context of buyback offers would certainly lead to a blunder; you will have to evaluate each offer on its merit only.

SOME CLARIFICATIONS WITH EXAMPLE
Consider the example of Monnet Ispat Limited; announced the buyback of equity shares on Dec. 22nd 2011 with the maximum offer price of Rs. 500, and the prevailing market price of the share was around Rs. 358.

What do you think of this offer? Is it an opportunity with entirely the win-win situation?

Monnet Ispat Limited will be buying the shares from the open market and not from the shareholders, and the price of Rs. 500 is only the maximum price at which they can buyback their shares. This is the upper limit beyond which the company can’t buy their shares from the share market.

So, when Monnet Ispat Limited has set up a maximum price of Rs. 500, it only means that they can’t buy shares at a price over Rs. 500, instead they can buy the shares at any price below Rs. 500, and can certainly buy it at the Rs. 358 or so at which it’s currently trading.

Had it been the offer where the company had opted to buy its shares back from the investors directly, the 500 number had more importance, but then they would not have even chosen such a high number.

Monnet Ispat Limited announced that buyback offer is for shares not exceeding Rs. 100 crores being maximum offer size representing 4.97% of the total paid-up equity capital and free reserves. At the time of announcement, maximum offer price was at 40% premium.

Now is it possible that someone buys the shares at lowest possible level and then sells them back at Rs. 500 in a few days, pocketing around 40% returns?

This simply won’t happen because usually there are more shares offered for a buyback than the company actually wants to buy. Therefore, in this case they buy back the shares in the proportion of the over subscription. So one will only get a part of his/her shares bought back, and if the price comes down below purchase price after buyback fiesta then for disposing of the remaining shares he/she might have to wait for long.