If the companies in your portfolio generate healthy cash flows, that’s good. But if they also invest the cash flow sensibly into high-growth areas, they’re almost perfect. Found one of these paragons?

THE CHOICE of business to invest in is perhaps more important than any other decision an investor must make. Year after year, some businesses are just more likely to produce superior returns than others. Many believe that the choice of
management is the most important factor in an investment decision, but even a competent management can do little if the company happens to be in the wrong business, possibly for historical reasons.

Business should not be confused with sector. Within a sector, there can be a multitude of business models. For instance, within the telecom sector, you could have three companies — one operating basic and cellular services, another in the
networking equipment space, while a third could be making a commodity product such as jelly-filled telecom cables. To club all these together as part of the high-growth telecom sector, and therefore competing investments for an investor’s
portfolio, would not only be inappropriate, it could be disastrous.

Free cash flows… So what makes for a good business? Perhaps the most important factor is the company’s ability to generate free cash flows on a sustainable basis over a long period. Free cash flow is the net profit plus depreciation less the capital expenditure required to maintain a minimal unit volume growth for the company. This is simply the cash that flows annually into a company after it has paid for all regular capital expenditure.

The best businesses generate lots of free cash flow — a very good example is Hindustan Lever, which has a history of using these cash flows to make strategic acquisitions, which have strengthened the company significantly over the years.
Another sector with a consistent track record of free cash flows is pharmaceuticals. Here again, the bulk drugs business is more of a commodity business and cash flow generation is erratic compared to formulations, especially OTC drugs, which are good cash flow generators.

Even in the high-growth technology sector, there are many different kinds of business models. Most Indian software companies, including Infosys and Wipro, are significant free cash flow generators, as opposed to companies such as Zee’
s Siticable which need to invest large sums of money to generate sizeable profits. Since commensurate revenue and profit flows are likely only with a lag, free cash flows are likely to remain deeply mired in the red for the next few years.

One of the main reasons why the dotcom revolution was doomed from the very beginning was the inability of these companies to generate free cash flows. While venture capitalists were eager to meet the cash flow demands of these
companies when the IPO market was strong, their inability to move to a revenue and cash flow generating model has led to their predictable demise. The commodity sectors typically go through a cycle where they make significant cash
flows during the boom years but are usually forced to spend this money in capacity expansion, modernisation and fending off competition. As a result, years of strong free cash flows are few and inconsistent.

The sustainability of free cash flows is also important. In certain cases, this may be in doubt — for instance, the cigarette companies’ future is a forecaster’s nightmare. On the one hand, you have a huge bidi-smoking population, which should normally move towards cigarettes. And yet, if the trend in the West and the increasing concern about tobacco are anything to go by, one hesitates to predict growing free cash flows far into the future.

… and where they go. Generating free cash flow is not enough. The ability to utilise it wisely is just as important. This is where management comes in. A good management puts the cash flows either back into the business or into acquisitions
or gives it to the shareholders as dividends and buybacks.

A very interesting case here is Bajaj Auto. In 1997, Bajaj Auto was the darling of teh stock market. It was a market leader in a high-growth segment of the automobile market, generating substantial free cash flows, which it found difficult to invest back into the business. Part of this was due to the bad management decision not to invest sufficiently in R&D. So much so, the cash pile in Bajaj Auto grew almost alarmingly, helped along by the company’s GDR issue of $110 million a few years ago. It is only recently that the company has used a buyback to reduce some of this cash pile. But even after returning almost Rs 700 crore to shareholders, it is still sitting on a mammoth Rs 2,000 crore (worth almost Rs 180
per share). It is no surprise that Bajaj Auto’s stock price has gone nowhere in the last few years. It is currently quoting at half the offer price of its GDR (Rs 540 per share, adjusted for the 1:2 bonus).

The ideal company for investment is one that’s able to invest these cash flows profitably in growth areas, preferably within the business itself. Indian Shaving Products and Birla 3M are good examples. While some managers have been
smart enough to handle diversification well, the best businesses are those where the potential for growth is large enough for the management to avoid the effort of trying to be jack of all trades. One struggles to find Indian managers who have
done a brilliant job at capital allocation — Azim Premji and Aditya Birla are the shining examples here. However, most of Indian corporate history is full of ill-advised, poorly managed diversifications, which explains why of the 20 largest
weighted Indian companies, only two (Reliance Industries and L&T) are diversified. To its credit, Bajaj Auto has at least not used its cash reserves for diversifications.

Other clues. What other attributes should an investor look out for? Warren Buffett advises investors to buy into a business that is so simple even a fool can run it — for, as he says, eventually some fool will. If you need to be a rocket scientist to understand it, you should probably give it a pass. This is how a great investor like Peter Lynch found a large number of brilliant stock tips in his wife’s shopping basket. (For more on how you can use the Peter Lynch principle to pick stocks, see A housewife’s guide to stock-picking.)

Predictability is another characteristic to be preferred. Change, though good from a social point of view, is often the investor’s enemy. This is one reason why the fast-moving consumer goods sector is one of the surest places to find good
investment opportunities. People are loath to change their bathing, cleaning and eating habits. Companies that can capture a good share of mind of the customer find their revenues growing at a predictable pace for years to come.

Similarly, the Indian software services sector is part of the powerful global trend of outsourcing, and hence one can be reasonably sure of high growth for the next four-five years. However, being part of the technology sector exposes this sector to a degree of unpredictability that can take a heavy toll on valuations.

So, when you go about building your ideal portfolio, take a long, hard look at the businesses your companies are engaged in. If the business is easy to understand, reasonably predictable and generates free cash flows consistently, go ahead and invest. If the management allocates the free cash flows sensibly in growth areas, you may have found the perfect pick for your long-term portfolio.

There is compelling evidence to suggest that this market is near its bottom.

ONE OF my uncles called me the other day, seeking advice on his investment strategy. Although he is quite astute in his line of business, he has generally depended on me for investment advice. So, he calls on me off and on. I launched into my usual harangue about how stocks were very cheap and a great investment. At which point he moaned: “My investments in equity mutual funds have depreciated 60 per cent. Hence, I have now decided to invest only in debt funds. At least, my money will be safe.”

It seemed like sound logic. Principal protection is one of the things that should be uppermost in the mind of any investor. A wise man once wrote: “The best way to make money in the stock market is not to lose any.” My uncle also quoted to me
the fairly fancy returns that debt funds had averaged over the past couple of years. I was left with no answer to this line of argument.

As I mulled over these thoughts and went to bed that night, it finally hit me like a hammer on the head. Debt funds have done so well in the past two years because interest rates have declined substantially during this period. As industrial
growth has slowed down to a dribbling pace, the need for funds has dried up significantly. Even the huge borrowings by the government (which despite all promises, continues to bloat like Obelix) have not been able to keep interest rates
at historical levels. Add to that low inflation, due to lower commodity prices and a deflationary environment, interest rates in India are now at their all-time low. Debt funds that bought bonds at higher interest rates find these bonds trading at a premium, which has significantly boosted their NAVs (net asset values).

Equities have traditionally had an inverse relationship with interest rates. There are two reasons for this. High interest rates raise the cost of loans, and depress corporate profits. The other, more significant factor is that the PE (price to
earnings) ratio — the rate at which earnings are discounted by the market — has an inverse relationship with interest rates. In fact, many experts argue that the floor PE for a stock market is the inverse of the interest rate.

This implies that at the current interest rate of 10 per cent, the floor PE should be 10, while back in 1996-97, when IDBI and ICICI floated bonds offering 16 per cent interest, the floor PE should have been 6. Why is this so? The major difference
between debt and equity is that while the former guarantees a fixed cash flow every year, the cash flows in the latter are uncertain. Over long periods of time, equity returns should beat rates of interest. Otherwise, the company will not be
able to pay interest to its debt holders either. So, equity should be priced at a PE that allows for some growth in cash flows — and therefore at some premium to the inverse of the interest rate.

When investors were offered a return of 16 per cent for a period of five to 20 years by IDBI and ICICI in 1996-97, they jumped at the offer. However, at today’s low rates of interest, few investors are excited by the return. They are shifting to
debt more out of a fear psychosis rather than as a rational investment decision. The reasons for fear are not hard to find. We have just had a major collapse in the stock market. There is a war going on, and the prevailing theme in the market is
that of protection of capital.

I would like to propose a contrary thesis. This is the first time in the past 10-12 years that dividend yields of many top-notch corporates are trading at above the rate of interest. This means that the returns you would get in the form of dividend at the end of the year by buying shares of these companies would be higher than what you would get by investing in bonds of these very companies. ICICI is an obvious example. Besides, unlike interest income, dividends are tax-free in the hands of the investor.

Yes, problems exist. Industry continues to founder. The slowdown, which began in 1997-98 and was then foreseen by many as a temporary one, has now stretched for five years. A typical economic cycle lasts seven to nine years at worst. What that indicates is that the worst is perhaps behind us, or close to being so. Surprisingly enough, despite the industrial slowdown, the GDP (gross domestic product) has continued to chug along at 5 per cent plus rates, largely due to the
robust growth in services.

Can we say that we are at the bottom of the cycle? I believe that it is foolish to try and predict the bottom. Not even the most astute economist can predict that. What we can say with a fair degree of certainty, given the data before us, is that
the probability that the next three years will be better than the past three from an economic standpoint is quite high. There is also some sign of improvement in the agricultural sector, which had suffered from two successive bad monsoons. Given India’s dependence on this sector, this should provide welcome relief. The latest round of cuts in the bank rate (the rate at which RBI lends funds to banks) and the cash reserve ratio, or the CRR (the percentage of deposits banks have to
maintain with the RBI) could perhaps provide the trigger that agriculture and industry need.

The truth is that it is darkest before dawn. While it is too early to say whether dawn is near, one can say with a reasonable degree of certainty that the economy is not near dusk. The external fallout of the war being waged in Afghanistan and the US (bio-terrorism) is very difficult to predict. The current rally in software stocks seems more because they were oversold and had reached ridiculous valuations, than any improvement in the external environment.

Selling your shares now and buying bonds could prove to be as much of a mistake as buying technology stocks in January 2000 was. For the market, looks ahead! And from the depths of a bear market emerges the first seed of a bull market. While that seed may need water and sunshine in the form of sensible government policies and forward-looking regulation to really blossom, selling out in fear now could be a blunder that you may live to regret.

By allowing preferential allotments at almost ridiculous prices Sebi is guilty of leaving minority shareholders in the lurch.

THE STOCK market here is strangely reminiscent of George Orwell’s Animal Farm – all investors are certainly equal, but some appear more equal than others. Take, for instance, the pampered institutional investors. Everything in the market
seems to be made easy for this tribe. Even Sebi (the Securities and Exchange Board of India), whose mandate is to protect the interest of retail investors, frames its regulations in tune with the demands and desires of institutional investors.

I was looking at the list of stocks that have outperformed all others in the past year and a half (when the Sensex peaked) and one stock grabbed my interest: HDFC.

Over this period, HDFC is up almost 70 per cent; comparatively, the BSE Sensex is down about 35 per cent over the same period. Digging into the reasons for this superlative outperformance, I found that while there were a number of factors
(strong demand for housing, tax benefits for the sector, defensive qualities) that could be responsible for this, many of these were shared by other players, who have not performed half as well. It struck me that perhaps the biggest reason for
the stock’s sterling performance is this: when Standard Life (with which HDFC entered into a tie-up and entered the insurance industry) wanted to increase its stake in the company, HDFC did not make a preferential allotment at the 26-week average price; it asked Standard Life to buy the shares from the secondary market.

This, I believe, is a landmark move and reflects the shareholder-friendly attitude of the HDFC management. Why should any investor be made a preferential offer? I could not come up with a satisfactory answer except that companies that want large institutional investments need to pander to these investors’ whims and fancies.

The principle that the regulator and the management of a company need to keep uppermost in their mind is that all shareholders are equal and no one should get preferential treatment over others. It is the regulator’s job to ensure that this happens. Often, preferential allotments are made by unscrupulous managements who rig up share prices and then offload these shares to mutual funds/foreign institutional investors. In these times of low share prices, we could be subject to the reverse. Managements can make preferential allotments to themselves or their friends at ridiculously low prices and offer to buy back shares from small holders. A small shareholder, faced with the prospect of delisting of the
company’s shares, has no choice but to sell to the promoters. Recently, Otis bought back its equity at Rs 280 per share. But in 1999, the same company bought back M&M’s share of its business at Rs 360 per share. Otis got round the Sebi regulations because there was a significant time gap between these offers.

But is justice being served here?

We are now likely to see a spate of buybacks, often at prices that are not fair to minority shareholders, and more delistings. I remember the case of Bharti Telecom; despite owning assets that were probably worth Rs 500 per share or
more, the company offered only Rs 96 per share to its minority shareholders. The promoter group already owned about 90 per cent of the shares, so the minority shareholders had no say in the price on offer. Note that Bharti Telecom is the
parent company for all of the Bharti group’s telecom ventures. I recently read that the group is targeting revenues of $1 billion; Bharti Telecom, however, was offered a valuation of only Rs 160 crore ($40 million) for the company. That is
nothing but a crying shame.

It is quite clear that Sebi’s regulations on buybacks and offer prices fall way short in protecting minority shareholders’ interests. Enlightened regulation would give minority shareholders the same rights as the management of the company or its institutional interests. To make it fair, the minority shareholder should be given additional rights since he does not have the clout that the other two categories of investors seem to have. I would suggest the following:

All preferential offers (to buy back or sell shares) should be accompanied by a put and call option to all investors. This will allow them to either sell their shares or buy more shares (in proportion to their holdings) at the same price that’s offered to institutional investors.

Delisting of a company needs to be made much more stringent, as minority shareholders are often forced to offer their shares for fear of not having an exit option. No company promoted by the same group should be allowed to access
the capital market for the next three years.

Only if such proposals are executed can we hope to get a fair deal for the minority shareholder, who, after the battering he has received in the stock market over the past 10 years, has probably abandoned this investment avenue for good. Mr
Mehta, are you listening?

Those opposed to the new trading rules are looking only at the short term. Fact is, in the long run, the changes will do a world of good for the market.

THERE HAS been a lot of hue and cry over the string of systemic changes (rolling settlement, options, uniform trading cycles) introduced by Sebi (Securities and Exchange Board of India) with effect from July 2. Market-watchers had been
awaiting this day with bated breath, as the general perception was that the market would react adversely to the changes and take another dive.

The D-day has come and gone. And though the market rallied that day, the truth is that damage was inflicted on the market four months earlier. The BSE (Bombay Stock Exchange) Sensex, which was at 4,386 on 1 March 2001, collapsed under the triple whammy of the Tehelka expose, the Nasdaq crash and the announcement of rolling settlement. Now, given that the Tehelka revelations seem to have blown over and the Nasdaq, though still weak, has recovered from the
depths it plunged to in early-April, does that mean the blame for the market fall can be squarely placed on the new trading rules (follow this link to read about them)?

The old gives way… In order to answer that, let us first see how the current trading system is different from its predecessor, and what Sebi is trying to achieve with these changes. The erstwhile weekly settlement cycle spanned five days — for instance, Monday to Friday on the BSE. So, on the BSE, you could buy (or sell) shares on Monday, but you didn’t have to necessarily pay money (or deliver shares). Anytime during the same week, you could do a reverse transaction, and square off your trade. A five-day trading cycle encouraged speculation, as traders played for small gains accruing from the volatility in the market.

Another, more pernicious evil was the practice of switching positions across exchanges. This was made possible by the fact that trading cycles differed across stock exchanges. While the BSE followed a Monday to Friday cycle, the NSE (National Stock Exchange) had a Wednesday to Tuesday cycle. So, a trader could take a position on the BSE on Monday, liquidate it on the BSE on Wednesday / Thursday / Friday and simultaneously open up an identical position on the NSE.

Come Tuesday, the settlement day on the NSE, he could again switch his position back to the BSE. That way, he could skip paying margins on both exchanges; the only cost he incurred was the brokerage.

The BSE and the NSE were not the only exchanges used for such speculation. The CSE (Calcutta Stock Exchange), where settlement took place on Thursdays, was particularly popular for this purpose, as it is regulated less stringently. The net
result was that it was impossible to estimate the total open position in the market — and therefore, near impossible to regulate the market.

The different trading cycles allowed operators to maintain highly leveraged positions without having any collateral to back these trades in the form of margins. As a result, when Sebi announced mandatory rolling settlement in 246 actively-
traded stocks and uniform trading cycle (Monday to Friday) for other stocks across all exchanges, operators were forced to scale down their open positions, resulting in carnage on the market.

…to the new. Besides uniform trading cycles, much-needed to curb unbridled speculation, the other — more controversial — measure is the replacement of the age-old badla system with options (on stocks and indices). This is not the first time that Sebi has tried to do away with badla. It did so once before in 1993, only to reintroduce it around a year later.

Although badla worked well as a speculation mechanism for a long time, it suffered from two drawbacks. One, It didn’t allow a clear-cut segregation between the cash market and the forward market, as is the global norm. Two, the method
of calculating the badla/undha badla charge was not very transparent.

Options address both these problems — and more (for a primer on options, click here). Although there is plenty of initial scepticism among speculators on this new instrument, in time, it might turn out to be the best thing to happen to them.
Speculators tend to give a short-shrift to discipline. Most live on hope rather than on any sort of practical approach to business. Losing trades typically become long-term holdings — never mind the fact that some of these companies have
annual reports that would give even a trained analyst nightmares.

Options, however, enforce a discipline. If you go long by buying calls, you know your downside at the outset. You cannot lose more than the premium you pay on the call; the same applies for puts as well. From a speculator’s point of view, this
works like a stop loss.

Right now, volumes in options are abysmally low, as market participants don’t fully understand these complex instruments. The low liquidity in the market, however, might turn out to be a boon for retail speculators. In the high liquidity go-go period we witnessed till recently, select speculative stocks fluctuated wildly during the course of the day, creating possibilities of huge profits. This created a casino-like buzz in the market, a buzz that even turned on sedate investors. They punted on the market, only to pay a heavy price to the very operators who create the buzz. With volumes drying up, there is now less incentive for them to play the market.

That’s good because speculation is not a good, viable money-making strategy for retail investors.

Carry forward the reforms. From the market’s point of view, the most important function of a speculator is to infuse liquidity into the market, which is essential for efficient price discovery. Today, the top 10 traded stocks account for 90 per cent of trading volumes on an exchange. If you want to buy shares in companies other than these 10, you will have to incur a significant cost in terms of the bid-offer spread, which has, in fact, widened on account of the poor liquidity.

Here, Sebi needs to do more. It needs to promote stock lending more aggressively so as to draw in arbitrageurs and create liquidity. While investors are heaving a sigh of relief that their wealth is not deteriorating at a steady rate, the regulator needs to do everything possible to infuse more liquidity into the market – or else, the cure could be far worse than the ailment.

Overall, Sebi’s measures bode well for the long-term good of the market. The circumstances under which these measures were announced — a reaction to the events that rocked the market in March — can be questioned, but not their efficacy. These measures might also sacrifice the short term for the sake of the long term, but that’s okay. The market will take its own time to understand the new instruments that it has to deal with, but it will come around.

A few years ago, when Sebi announced compulsory dematerialisation of shares, brokers had raised a similar uproar. But today, aren’t we — as well as brokers — glad we don’t have to chase down registrars for share certificates and dividend
cheques lost in transit. A child has to fall to learn to walk, and then run. The transition the market is going through is similar in nature.

However, Sebi’s job is far from over. It still has many hurdles to climb. The biggest one confronting the markets right now is insider trading. Only when this problem is transparently resolved will we see the return of the retail investor to the market.

The sad story of our markets (as also of our economy) is that it always takes a crisis to usher in change. Some people refer to this as progress through chaos. All the changes that have been brought about by Sebi — be it paperless trading or
rolling settlement — have been opposed tooth and nail by exchanges. Yet, today the Indian stock market is one of the most mature among developing countries. In fact, the development of our stock market far exceeds the development of our economy – the sad part is that we have to thank Harshad Mehta and Ketan Parekh for that.

An honest and capable management could make a world of difference to a company’s performance on the bourses.

A FRIEND recently pointed out to me that the charts of Himachal Futuristic and Infosys look almost alike. At a cursory glance, there did seem a lot of similarities — the graphs have almost the same shape. There is one vital difference though.
One share of Himachal was worth Rs 88 on April 1, 1999, rose to Rs 2,600 in March 2000 and is now back to square one. Infosys, in the same timeframe, started at Rs 1,300, rose to Rs 13,000 and even now, at its worst, is worth a good
two times more than its value on April 1, 1999. There are, perhaps, many factors responsible for this, but the one I would single out above all others is the quality of management.

The integrity and ability of the management of a company is the last word in an investment decision. In my book, this is the most important factor going into the investment decision making process. An honest management that does not know
how to run its business profitably is as bad as a dishonest one that makes brilliant business decisions but none of the increased profits actually flow to you, the shareholder.

If you remember, one of the central tenets of security analysis that we established was that an investor is a part owner of the business. This tenet is valid only if the management also thinks likewise. You can be a part owner in a business only if
the management believes that the minority shareholders are owed their share of the business profits. Most Indian managements believe that the shareholder is just some faceless stupid fellow who keeps coughing up money to fund their
expansion plans. Some of the smarter ones are realising the folly of their erroneous beliefs. For shareholders are now learning to vote with their feet.

Let us also debunk the myth here that all Indian managements are chors and all firangs or MNCs are managed well. We have enough examples of MNC managements taking shareholders for a ride. Witness the recent merger of Indian
Shaving with Geep and Wilkinson at a swap ratio that is grossly unfair to minority shareholders. (Read more about that here) The stock price is now almost one-eighth the value recorded in February 2000. And this is a company that was the
investors’ darling just a couple of years ago. A fine way to pay investors for their enthusiasm.

This is not one stray case – Indian corporate history is littered with numerous such examples where the interest of the minority shareholder has been sacrificed for the benefit of the majority owner. Just a few years ago, a lot of MNCs decided to put their new product launches into 100 per cent subsidiaries (For more on that, follow this link). These managements could never even dream of doing something similar in the US (the most transparent capital market of all) because not only would their stock crash, they would be rapped by the regulator. Here, alas, chori is so rampant in all parts of society that nobody even sits up to notice that there has been one more.

Honesty is a necessary condition, but is not the only one by which to judge a management. An honest but incapable management is like putting your most trusted chowkidar behind the driver’s seat on a cross-country drive in the
mountains. For, while the chowkidar may be extremely loyal to you, he may not have the slightest idea of how to manoeuvre a vehicle on treacherous, hilly terrain.

Top management ability is tested especially in a crisis, but also on a daily basis because good managements put systems and processes in place which allow for the smooth functioning of the company at all times. Let us take the example of
Hindustan Lever, which has systematically hired the best graduates from the premier management and engineering institutes, put them through a gruelling training programme and groomed them over many, many years into good
managers. It is not surprising that HLL has provided the Indian private sector with more CEOs than any other company. HLL is not the only one either. A number of corporate houses (HDFC, Sundaram group, to name but two) have an
impeccable managerial record and the market has usually rewarded these companies with significantly higher price earnings multiples.

Why is it that despite India having a track record of more than 5 per cent GDP growth through the 1990s (when we slow down, we grow at 5 per cent and when we are on a high growth path, we are growing at 7 per cent. Somehow, I can
never understand talk of recession), the BSE Sensex is below the high touched in 1991? The answer is pure and simple – the market is not sure about the quality of management of the corporate sector as well as that of the country. And unless we use the current crisis to clean the system once and for all, we will find ourselves coming back to these levels again and again.

Here’s the chance to restructure your portfolio.

THE WORD ‘carnage’ best describes the happenings on Dalal Street of late. The pink papers are awash in a sea of red and the rumour mills are spinning out a new sob story every day. Yes, there’s a lot of bad news out there.

Negatives abound. To start with, there’s the threat of a US recession–after several years of staggering growth, the US economy is showing signs of a slowdown, a prospect that has most world markets in a tizzy. US technology companies are finding it hard to match the astounding growth rates of the previous two years. As a result, technology stocks are getting hammered.

Then, there is the Tehelka expose, which threatens to bring down the government. And above all are the allegations of price manipulation and a payments crisis on the Indian bourses. In other words, there’s really nothing but bad news floating around. So, is it time to hit the panic button before the whole shithouse comes down in flames?

Ignore the momentum. The answer to that is an unequivocal no. Buying stocks during a frenzy and selling out in a crash is what sheep would do. And we credit you with far greater intelligence than that. The logic of the panic-stricken is that
there is downward momentum–so the market is going to go lower. Or something like “let me sell now–I can always buy it back lower”. This is a bit like the logic that drove IT stocks to five to 10 times their current values in February 2000. Would you sell your house just because the value of your locality is falling in the real estate market?

The truth is that when stocks fall off a cliff, it is precisely because of all the fears being expressed by all and sundry. While I cannot say with certainty that all these fears are unfounded, the truth is that stock prices currently reflect much of the bad news. You have to ask yourself two questions. One, am I certain that all these fears will come true? Two, will all stocks be affected uniformly?

Is the sale of toothpaste, for instance, affected by any of these fears? Will banks stop functioning? The market does not reward those who think with the crowd–because then you are part of that mob that is either rushing into a room or getting out of another. And you know what happens when you do that!

So, what should you do? You can either despair over what might have been or turn the prevailing weakness in the market to your advantage. Fact is, there are great money-making opportunities out there, provided you go about it the right way. A key component of this exercise entails reviewing your investment portfolio.

We present a five-step guide to carry out a mid-course correction.

STEP 1: Pare your trading positions

Much of the bloodbath on the bourses is because speculators (today, this includes people in all walks of life, thanks to the proliferation of trading terminals) were carrying positions far beyond their means. Trading on margin entails a lot of
risk. Badla, for instance, allows you to leverage yourself three to five times (in plainspeak, this means you can buy up to three to five times your bank balance in the forward market). When the market turns bad, as it has, a 20 per cent fall in
your stock can wipe out your entire capital in one stroke. While the risk of owning stocks is overplayed in our country, trading on badla is definitely hazardous and can lead to serious losses. We would advise you to either take deliveries of your trading positions, or square off the trades and book losses.

Agreed, some of you are probably carrying huge amounts of losses in your trading account, and the urge to make that one trade that will help you recover your losses is perhaps very strong. But that is precisely what a losing gambler does–he bets more and more until he loses everything! This should be a lesson for all speculators to stop trading on the basis of momentum. Don’t confuse speculation with investing, and you won’t find yourself on the wrong side of reason.

STEP 2: Clean up your portfolio

One of the peculiar features of stock markets is that the baby often gets thrown out with the bath water. When a crash like this occurs, in an effort to make good the losses of losing positions, speculators often have to sell everything they own.
This results in a lot of good companies getting hammered for no good reason.

Such aberrations in the market are a good time to do some spring cleaning of your portfolio. Take a good look at your stock holdings, and ask yourself the reason for holding each one of them. If you understand the business of the company you own and have faith in its management, hold on. Selling in panic would be disastrous.

However, all of us have some skeletons in our closets–stocks we continue to hold simply because we are continuously reminded of the loss we’ll have to face up to if we sell them. As long as we don’t sell, we don’t have to acknowledge the loss.

Ask yourself if your assessment is based on reason or driven by hope? If it is the latter, you may be better off taking that hit, and reinvesting the proceeds in commonly-acknowledged quality stocks. The returns might not be spectacular, but
they will be surer.

Here are a few quick tips that will help you in this flight to quality. The first thing to check about the stock you own is the integrity and intelligence of the management or the promoter. Any hint of notoriety on their part is good enough reason to stay away from the stock.

Next on your checklist should be the quality of the business, as measured by its ability and track record of free cash flow generation (net profit plus depreciation less capital expenditure) and a high return on equity. The last point on the
checklist is the tax rate. A high tax rate (above 20 per cent) usually implies that the company is not fudging its numbers. While a low tax rate does not necessarily mean that there’s something wrong, when you have 7,000 companies to choose
from and no access to management, it’s better to be safe than sorry.

STEP 3: Review your sectoral exposures

This is also a good time to do some sector reallocation. Technology stocks, which have been the flavour of the market for the past two years, are clearly out of favour. And while there are a lot of good software companies out there, generating healthy cash flows and with decent management to boot, there is a lot of junk in the name of technology and high growth. Also, the level of uncertainty in the technology sector has definitely increased over the past few months.

Moreover, current trends suggest we are not about to enter a period of certainty any time soon.

Although the technology sector does offer the lure of making quick returns on a rebound, there is no telling whether this bounce back will happen from current levels or from much lower levels. Hence, we would recommend you to wait for the
air to clear a bit before taking an aggressive stance in this sector.

The bearishness in the market has also brought down many old economy warhorses to reasonable valuations.

Given the current risk-reward equation, both new economy and old economy stocks seem to offer a similar upside (as long as you stick to good companies at reasonable prices), while the potential downside is not quite known for technology
companies. The intelligent investor would keep a balanced portfolio and ensure that no sector forms an extraordinarily high proportion of his total equity portfolio.

STEP 4: Rethink your asset allocation

There is no doubt that equities are attractively-priced at this point in time. More so, when you consider that avenues for earning a good rate of interest to beat inflation are few and far between. In many cases where they do exist, the  accompanying risk could be significant.

This crash provides the lucky few who have stayed overweight on debt to go out and increase their equity exposure. The exact quantum of this shift would depend on your income needs, age and appetite for risk. Experts believe an individual’s
equity holding in a portfolio should range between 25 per cent and 75 per cent.

Depending on where you fall in the spectrum, it may be a good time to increase your exposure to equity.

STEP 5: Stagger your purchases

While share prices are definitely low right now, there is no telling they won’t go lower. When the market gets nasty, the pendulum usually swings to an extreme. It is very tough to say whether we have reached that point. We may have, but no one really knows. So, instead of trying to catch the bottom, stagger your purchases.

Make some purchases now and then wait–if you are lucky, you may just get a point some time soon when the howls of panic are so loud that the roar is deafening. That would be the time to do some aggressive shopping. But remember at all times to stick to quality stocks.

The last word on investing is patience. The stock market is not for people who consider it to be a casino, where you make your money (and lose it) quick. Yes, the losses can sometimes be quick and easy, but the rewards only come to those
who have the ability to wait. So, once you have invested, do not expect your money to double in double quick time–and don’t keep looking at the pink papers daily to see how your stock has done. Do you check the market price of your house or your real estate investments every week?

Remember that Dire Straits song: “There’s always sunshine after rain/these things have always been the same”? To put it in pallid prose, bad times don’t last forever. Nor will this market remain forever in the dumps. But just make sure your ship is ready to weather the next storm.

It’s the season for buybacks, with several companies choosing to return cash to shareholders rather than invest it in other avenues. What does this mean for investors?

THE INVESTING public is today as familiar with the terms ‘buyback’ and ‘public issue’ as it is with ‘rolling settlement’ and ‘margins’. Around 25 companies have recently completed buybacks, and at least a dozen more are in the process of
doing so. Public issues have been around for umpteen years now (they are pretty unpopular these days though, thanks to the enormous amounts of money lost by small investors), but buybacks are a relatively new concept.

What are buybacks? A buyback is essentially the reverse of a public issue. While in the latter, a company raises money from the public to fund expansion or diversification, in the former it returns cash to its investors. So, money actually
flows in the reverse direction — from the company to shareholders.

This cash for funding buybacks comes from various sources. In some cases, it’s from the sale of assets (like Madura Coats and Raymond), while in others it’s from a mountain of cash collected over the years (Bajaj Auto). In the context of
buybacks, mountains of cash doesn’t mean the absolute amount of cash with a company; rather, it is a company’s cash holding as a proportion of its net worth.

Hence, even a company of a smaller size (Crisil, to name one) could be said to be sitting on a mountain of cash.

Why buybacks? Historically, managements have considered themselves to be the rightful guardians of the cash their company generates – they decide where the cash is to be invested. Unfortunately, the track record of Indian managements in capital allocation is rather dismal. If a company has few investment opportunities other than debt instruments, buybacks are one of the best ways of utilising free cash in its books. After all, if a company earns 16 per cent or more in its core business, it doesn’t make much sense for it to invest in instruments earning 11 per cent or less.

The fact that a company is returning cash to its shareholders does imply a dearth of investment opportunities within the company. The business the company is in could be facing tough times, which justifies it not committing fresh investments at this point in time. Further, the company may not wish to diversify into unrelated areas, where it doesn’t have sufficient expertise. Also, if the company is a high free cash flow generator, it is perhaps able to fund its growth quite well from
internal accruals.

By returning cash to investors, the company can improve its return on capital employed (RoCE). Also, many companies run quite well on their existing operations, and sucking out cash actually helps maintain financial discipline. It’s certainly better than investing in projects of dubious profitability just in order to become a larger company.

Returning cash to shareholders is a far better strategy than that adopted by some companies who went ahead and bought units of equity mutual funds in February and March 2001, when the market was at its peak. With cash in their hands,
investors can then utilise it in a manner that suits them best — in debt securities or in shares of other companies that are growing faster.

IPOs versus buybacks. Companies issue shares when they think they are overvalued. In the early-nineties, many of us marked our entry into the stock market through shares purchased at low prices through IPOs (initial public offerings) which, when sold in the secondary market, offered sizeable returns.

This was however an aberration, because till 1992, companies were forced to offer their shares at artificially low prices (thank you, O Controller of Capital Issues, the messiah of the small investor). Since then, however, companies have
been given considerable freedom in pricing their public offerings.

But according to Benjamin Graham, an intelligent investor should never invest in a public issue. Now, that’s a drastic statement and worthy of mention only because of the stature of the person making the statement. Graham’s logic is simple – companies mostly issue shares when market conditions are favourable for them to sell (think of the amounts of money raised over fiscal 2000 and 2001, and you’ll know what I mean).

The corollary is that a company will offer to buy back its shares when it considers them undervalued. While this is not always true (for instance, Bajaj Auto bought back its shares at Rs 400; the stock is now at Rs 260, having touched Rs 220
recently), it is reasonable to assume that buybacks do tend to provide a floor to stock valuations.

That’s because a company can buy back its shares only if it has cash on its books or it generates free cash flows. So, the stock price is not determined by some fancy PEG (price earnings to growth) ratio or someone’s imaginary valuation of
the company’s replacement cost, but by hard cash being paid to investors to exit their holdings. Evidence of cash in a company tends to provide a floor to the stock’s valuation. One of the reasons that even tech stocks got a bounce over the
past few months was that some of these stocks dipped to levels below the cash per share in the company.

Shareholder-friendly. In general, a buyback is good for shareholders, as the responsibility for investing the spare cash is passed on to the investor, who can then choose investments in tune with his risk appetite. Also, given the pathetic
track record of most Indian managements in the deployment of cash (often in loss-making megalomaniacal projects), shareholders are much better off with cash in their pockets.

Investors stand to benefit that much more if the buyback is below the book value per share of the company. This is akin to a company issuing shares at a premium. Buyback below book value will shrink a company’s absolute net worth, and therefore enhance return on equity, as profits (from other income) will not fall as much. The following calculation shows that a buyback would also boost a company’s earnings per share and book value per share, further enhancing value.

Just as an IPO bubble is symptomatic of an overheated bull market, large buybacks suggest that the overall price level of stocks is quite low – in fact, low enough for companies to pay cash to buy back their shares. After the severe downswing in stock prices, it hardly bears repeating that stock prices are low, but when insiders — and no one is more ‘insider’ than the company management — feel that prices are low, maybe we should be buying.

Buy good companies now and hang in there. Don’t let the opportunity pass by.

LOOKING AT the stocks pages in the daily newspapers makes me wonder if the world as we know it is coming to an end. The number of stocks hitting 52-week or all-time lows fills up an entire page. And many of these stocks were the darlings of the market just 12 months ago.

What causes such wild swings? These days, I often think of Ben Graham’s concept of a manic-depressive Mr Market. Up and about, prancing to some funky hip-hop one day, and so low the next that even K.L. Sehgal would sound cheerful in comparison. But why does this happen? Why is it that the same people who bought Wipro at Rs 10,000 in the hope that it would touch circuit breakers daily, do not want it at Rs 1,500?

Instant crorepatis. The answer to that lies in the lure of making a quick buck. Almost everyone who knows me has asked me for short-term tips — “something that will go up in a few weeks”. Well, if I knew that, I’d be smoking a cigar on a beach in my own island in the Pacific. But most people, dreaming of becoming crorepatis overnight, get caught up in the mad rush of the market with no clue about what they are buying and what they are paying for. They lap up the dreams that stock operators sell them and when things turn sour, as they seem to have now, they cry scam and abandon the market. Many of them swear never to return — until the next bubble comes along.

Time and again, stock operators have been able to drive prices to frenzied levels. It seems that we do not learn from our past mistakes. I wouldn’t be surprised if the same people who bought ACC at Rs 10,000 (Rs 1,000 adjusted for the Rs 10
face value) and Tisco at Rs 550 were the ones buying Global Tele at Rs 1,600 and Himachal Futuristic at Rs 2,800 odd. While the last time around, the name of the game was ‘cost of replacement of capacity’, this time it was momentum. The
media obliged by terming a few shares ‘momentum stocks’ and investors happily lapped this up. The funny side to this otherwise macabre tale is that investors (or should I say speculators?) were given a clue about things to come from the name itself. All they had to do was open a dictionary to check what momentum meant, and they would have known how this madness would end.

Moved by consensus. But these are wise words — after the event. And you are probably wondering why I wasn’t around to offer these words of wisdom when the market was up. I did — at almost every gathering I went to, I did not tire of telling
people that the market was overheated. But my warnings were usually laughed off. I was told I was a party pooper. I had no clue of how the New Economy operated and that an era of prosperity was about to dawn, which my short sightedness prevented me from seeing. So to avoid being beaten up, I shut up! What’s worse, I was swayed by the mood of the party and had to pay a price for joining in.

Back in 1991, when I was doing my management studies, I decided to play a game. I created a hypothetical portfolio that I would change on a daily basis. I would look at the daily newspaper, try to analyse the news, and on that basis, buy and sell stocks in my hypothetical portfolio. After a few months, I was a little surprised to find that my analysis was not leading me anywhere and that I was lucky to have kept my portfolio at a hypothetical level. Many investors tend to follow this same game with their not so hypothetical portfolios. Investing according to the news flow is the worst thing you can do. Because, more often than not, when the news hits the stands, scores of people have had the information or anticipated it long before. You are probably among the last group of people to get the news. So, be wary of investing on the basis of news !

Dealing with a manic-depressive. So how should the intelligent investor deal with Mr Market? Ben Graham suggests that you treat Mr Market as a manic-depressive partner in a business (Remember, owning one share in a company makes you a part owner in the business). One of Mr Market’s endearing characteristics is that he does not mind being ignored. If his quote is not of interest to you today, he will be back tomorrow with a new one, at which he will either buy your share in the business or sell you his share. The worst you can do is to join in his manic-depressive ways. However, if you know what your business is worth, you can take advantage of his swinging moods to your benefit.

The depressed market scenario now offers a number of buying opportunities for the long-term investor, both in the New and the Old Economy. For, while the software sector has fallen prey to expectations of a severe US tech slowdown, the
tehelka.com expose has meant that Old Economy has not been spared either. However, it is important not to buy everything that is down from its high — there are some stocks that will never regain their previous glory. Focus on companies with good management, intent on generating cash flows and do not invest on the basis of dreams that someone sells you. This is not to say that stocks will not go lower than they already are — the pendulum usually swings to an extreme and you would do better to stagger your purchases. But if you buy good companies now and hang in there, you should be able to look back at this next March as an opportunity you didn’t let pass. Be greedy when others are fearful and vice versa, and you can profit from Mr Market’s mood swings.