Paying tax on the unrealised gains!

Many start ups offer ESOP - Employee Stock Option Plan. To know more details
about how it works, you can follow this link

https://blog.cleartax.in/getting-esops-salary-package-know-tax-treatment/

Quick summary:
The companies give stock options (right to purchase, no obligation on part of employees) at a said exercise price, which is lower than the fair market value at a future point in time. These options would be vested (become live) after serving for a predefined time.  After the vesting period, the employees may choose to exercise the option i.e. convert the options to shares by paying the exercise price to the company.

There are two kinds of taxes which are involved in here.
    1. Perquisite Tax
    2. Capital Gains Tax
   
When the employee exercises the option, the difference between the exercise price and the fair market value (FMV) of the company will be treated as income of the employee (perquisite) for that financial year and will be taxed in his income slab accordingly.  FMV of a listed company would be the market price as on the exercise date and for an unlisted company, it would be as per the valuation arrived at by the company.  Most of the start-ups belong to the later category.

Capital Gains Tax is to be paid when the employee chooses to sell the stocks. For a listed company (listed means listed in India), short term capital gains (selling within 1 year of purchase / exercise) attracts 15% tax on the gains and beyond one year, it attacts no tax, as the STT is paid. For an unlisted company (or listed companies abroad), short term capital gains will be as per the slab rate (within the 3 years time frame) and long term capital gains (beyond 3 years) attract tax @ 20% with indexation or @10% without indexation
   
Coming to the topic of the post:
Think of the perquisite tax.  On the date of exercise, if the stock trades at a value lower than the exercise price, the stock options which the employee holds has no value at all.  He can as well put them into dust bin.  Who would want to exercise at a price higher than the market price.  Instead one can directly buy from the market at a lower price, if one still has confidence in the company.

On the other hand, let us say, the options are given at Rs 100 exercise price and the stock is quoting at Rs 175.  If a person holds 1000 options, he can exercise and get stocks valued at Rs 175 for Rs 100 by paying Rs 100,000.  Now, the difference between Rs 175,000 and Rs 100,000 is taxed at the income slab (say 30%) - it works out to be Rs 22,500.  And this is what I am saying as a tax for unrealised gain.  In a listed company option, one can choose to immediately sell it in the market and at least be comfortable saying the tax is paid for the realised gain.

In an unlisted company, first of all one has no idea about the fair market value.  Though it is done by following certain standard procedures, the person holding options has not much of transparency into how it is arrived at.  And, he cannot choose to sell immediately, because there is no market that exists for shares of unlisted company.  Paying a tax on this unrealised gain and ending up holding an illiquid and non-transparent share does not make so much of sense. There are very few exit opportunities in the unlisted category.  Either hope for an IPO or for an acquisition or merger.

And consider this case where the fair market value is much higher when you exercised (paying a lot of perquisite tax) and further drops much lower even below the exercise price.  Money down the drain!  In this way, you would have footed the bills of the company which provided you the employment and the government, which gave you the freedom to enter into these transactions.

I do not need to name, but, many e-com companies currently fall into this bracket.

Ramanujan's Magic Square

Yesterday I got a whatsapp forward which I found interesting.  The forward is about Ramanujan square. This is the Ramanujan square.

It is a magic square. Magic square is a square with 3x3 or 4x4 or any such square matrix filled with distinct numbers, whose sum when counted in multiple ways (horizontal, vertical or diagonal) remains the same.

You can have a visit to the wikipedia page on this topic. There are 24 different combinations (of 4 squares) in multiple directions and as 2x2 blocks which all add up to the same number - 139.

The wikipedia page above depicts the different combination as below

Image Courtesy:
Antonsusi shared under Creative Commons license.

This uses six 4x4 squares to depict all the 24 combinations. I have tried the same using a different illustration, with 9 4x4 squares instead of 6.  These 9 squares are created attaching eight Ramanujan squares in all 8 directions (N, S, E, W, NE, NW, SE, SW) of the center 4x4 square.

The first row of the Ramanujan's magic square is his date of birth 22 Dec 1887 written in Indian Style - 22/12/1887!

The Power of Tax Deferment

In 2011 December, IDFC Infrastructure Bonds got issued - which provided for an additional Rs 20000 tax-saving investment option beyond the usual 80C limit.  The quoted interest rate was 9% p.a. So, someone who was in a 30% tax slab, saved Rs 6000 in FY 2011-12 by investing in this bond. This Rs 20k with 9% p.a compounding would yield Rs 30770 after five years.  The interest on the bond is taxable as per the individual investor's tax slab.  The interest over 5 years is Rs 10770. For a person who is in 30% tax slab, this means a tax liability of Rs 10770 * 30% = Rs 3231 in FY 2016-17. The net inflow in FY 2017 is Rs 30770 - 3230 = Rs 27540.  This is for a net effective investment of Rs 14000 (remember Rs 6000 saved on tax).  Works to a very good 14.5% p.a CAGR.

Net tax outgo of Rs 3230 after 5 years is far better compared to a tax outgo of Rs 6000 currently!

There is an option to extend this for another 5 years. Assume this gets extended. Amount accumulated at the end of 10th year is Rs 47347, the interest Rs 27347 would attract tax @ 30% (based on the slab) which means effective net inflow will be Rs 20000 + Rs 27347 * 0.7 = Rs 39143, this on a net investment of Rs 14000 gives a CAGR of 10.83% p.a.  Definitely not impressive compared to the 5 year CAGR.  Figure out how!

Had it been taxed as long term capital gains (as the debt mutual funds are taxed), it would have been a different scenario.  We need to take into out the increase in cost inflation index from the investment year to the current year.  In 2012, it was 758, in 2016-17 it is 1125.   Indexed Cost would be 1125 / 758 * 20000 = Rs 29683.  The net gain of Rs 30770 - Rs 29683 = Rs 1087 will be taxed at 20%, which is just Rs 217!   Net post tax gain of Rs 10553, working out to be 8.84% CAGR  (assuming no tax benefit of Rs 6000 in the tax saving year)

If the investment had been kept for 10 years, 2006-2007 index was 519. Indexed cost is 1125 / 519 * 20000 = Rs 43352.  Total amount accumulated at the end of 10th year is Rs 47347, the difference is Rs 3995 which is taxed at 20% (Rs 800) Net post tax gain of Rs 26547, works out to be 8.81% CAGR.

Tax Treatment on Stock Split and Bonus Shares

Recently, I happened to look at a stock which was bought long back and forgotten.  For a moment I thought that the price has doubled since then, so possibly I can exit the position.  Since the stock was bought before one year, even if I sell, it would be considered as long term capital gains on equity and would not be taxed at all.

I was wrong.

I remember I bought 50 shares, but now I had 100 shares, when I looked at the corporate actions, I realised that the company has recently issued a 1:1 bonus.  So, if you had 1 share, now you will have 2 shares - accordingly the stock price would also have halved.  The total value of my position is still at a gain, but because of the bonus shares - not all will be treated as LTCG (Long Term Capital Gain)

Here it goes
2011 - Bought 50 Shares - Price 40  => Rs 2000
2016 - Have  100 Shares - Price 40  => Rs 4000

So, the original 50 shares - LTCG is Rs 0 - Then it was at 40, now it is again at 40
the additional 50 shares - Gain is Rs 2000 - Since it was allotted as a bonus - effective cost is zero - the entire value is gain and since it is recently allotted, this gain of Rs 2000 will be treated as short term capital gain (STCG) if sold within one year of allotment and taxed accordingly (@15%)

The way the Indian taxation works with stock split is different.  A 2-for-1 stock split will make the investor hold 200 shares of face value Rs 5 if he originally had 100 shares of face value Rs 10.  Note that the face value is not changed in the issue of bonus shares, but gets altered in the stock split.

Since these are the same shares whose face value have changed and because of which the number of shares got increased, the additional shares credited is considered to be bought as on the original date of purchase.  So, in the case illustrated above, if the company had issued a 2-for-1 split instead of 1:1 bonus, I would still be holding the same number of shares (but of half the face value - which is immaterial), all of my shares would still be qualified for LTCG if I sell it today.

Books 2016

2016 was a good year for my book reading habit.  Mostly I was able to use my long commute for the same.  I generally do not like long commutes, but it so happened that that was the case.  I have been spending around 2.5 hours a day up and down in commute alone.  I do not like the commute - especially in the Bangalore traffic, but the habit of book reading is the savior.  Book reading has become an almost essential part of my life, now.

These are the books which I completed in 2016
1. The Art of Thinking Clearly by Rolf Dobelli
2. Richdad's Cashflow Quadrant - Robert Kiyosaki
3. Nudge: Improving decisions about health wealth and happiness by Richard Thaler et al
4. Intelligent Investor - Ben Graham
5. Scarcity: Why Having Too Little Means So Much - Sendhil Mullainathan et al
6. Influence: The Psychology of Persuasion - Robert Cialdini
7. Fooled By Randomness - NN Taleb
8. The Goal 2 - Eliyahu Goldrat
9. The Little Book That Builds Wealth by Pat Dorsey
10. Extraordinary Popular Delusions and the Madness of Crowds by Charles McKay
11. Man's Search For Meaning - Viktor Frankl
12. One Small Step Can Change Your Life: The Kaizen Way - Dr. Robert Maurer
13. Beating the Street - Peter Lynch
14. As a Man Thinketh - James Allen
15. The Richest Man in Babylon - George Calson
16. Think and Grow Rich - Napolean Hill
17. The Way to Wealth - Benjamin Franklin
18. The Checklist Manifesto - Dr Atul Gawande

I realised that I like fiction much less compared to essays, biographies and conceptual books.

Started, but not yet completed
1. The Man Who Knew Infinity - Biography of Srinivass Ramanujan, Mathematician
2. Black Swan by NN Taleb
3. The Summons by John Grisham
-- In the first 2 instances, switched books in between - it is still on my to-read list. I did not like "The Summons" - so stopped reading.
4. The Little Book of Valuation by Aswath Damodaran (still in my list) - this is not a casual read, so waiting till I get a working time with this book.

I would like to do better in reading, this year.

The Goal 2

The Goal 2 is a sequel to the book The Goal by Eliayu M. Goldratt.  Goal talks about Theory Of Constraints.  Goal 2 talks about a concept called "Thinking Process".  The protagonist Alex Rogo is now EVP in UniCo managing three newly acquired businesses.  A printing company, cosmetics company and a pressure-steam company.  The book starts with the board of UniCo deciding to sell off Alex's 3 business and wanting him to turn around the struggling companies to fetch a better sale price.

Over the course, all the 3 divisions make a turn around after analysing the current situation and identifying what the market wants.  The printing company positions itself to give a better price per usable unit thereby cutting costs and reducing unwanted orders from the customers, creating value. The cosmetics company makes a turnaround by acquiring good shelf presence in return of reduced ticket sizes and frequent deliveries to the customers (shops) thereby reducing the financial burden of customers.  The pressure-steam, instead of selling the unit and spare parts, starts selling the pressure steam itself, thereby converting the capex of customer to opex.

The author introduces a negotiation technique involving visual articulation of common objectives and conflicting premises, which would help breaking the conflict.  The Thinking Process involves the construction of Current Reality Tree, Transition Tree and Future Reality Tree.

The Current Reality Tree is the wholesome flowchart of UDEs (UnDesired Effects - shortcomings) for a given objective, as of now.  This connects all the UDEs from one to another.  The premise is that all the UDEs are the experienced pain points which arise from majorly one or two main causes - the idea is to find such a cause.

The Future Reality Tree is built from the current reality tree, with an end objective in mind and creating possible paths for the same.  The paths will have negative branches for which a resolution is sought after. For example increasing sales is a path; reducing price (and thereby creating price war) is a negative branch which needs to be addressed.

The book emphasizes on the point that the product is not simply the physical product.  The product is the wholesome unit including the physical product, packaging, service, delivery along with the financial terms which the customer would value. It proposes to create a competitive advantage, especially sustainable competitive advantage, kind of a moat, which the competitors would find difficult to catch up.

Advocates one of the known but often overlooked idea.  The price of the product is not the cost plus markup, it depends on what the value that the product brings to the customer.  Or is equivalent to the value of the pain that the product or service offers to remove.

Towards the closing chapters, there is a significant talk on what makes a good strategy - an organisation needs to uphold the values of 3 key people - shareholders, employees and the customers.  Any idea which propagates to benefit one group at the expense of other is not a long term sustainable one.

Enjoyable read - this is one of the 2 novels that I read in 2016.

Happy New Year 2017

Wish you a very happy new year 2017!

Sometime back, I wanted to refresh my blog writing.  So, started it small in November and now in the last 2 months, I have written around 20 posts - most related to personal finance topics and products. Looks like it is a significant one considering my hibernation in the last two years.  The post I did before Nov 2016 was in Jan 2015 and that too a new year post, after a hiatus.

Seems I did well - but actually not.  I decided to do a post every day when I started.  But had to put off for many days.  Just procrastination and nothing else.  I got the inspiration from a Tamil movie "Pichaikaran" where the protagonist sticks to an arduous routine for 48 days. I thought why not I practice something for 48 days.  It did not work - though, I think I did better than nothing at all previously.  On a side note, the movie got an instant celebrity status after PM's announcement of demonetisation on Nov 8, 2016.

Similarly another activity which I wanted to renew was walking. I have been practising walking since late 2008 - but on and off.  The inspiration was my economics professor Dr. Tripati Rao, who is practising for around 20 years now!  The new year 2009 was coming, but I did not want to wait for it, I started sometime in December itself.  In the last one and half years, my long bus commute has been prefixed and suffixed by the walks.  But, I wanted to do it as an activity alone, not combined with the bus commute.  So, restarted it in the last few months. It is one of the most enjoyable activity.  I strongly recommend.  I used to use Sportstracker in the early days, now using Google Fit - I find people say it is not accurate - but works for me than having nothing.  At least I know that I am progressing.

I think I am too addicted to metrics - see I count the number of steps, count the number of blog posts that I did.  In the modern day where every minute of living generate data and metrics, it is something which we cannot avoid.  The editor (notepad++) which I am typing in keeps track of the word count, line and columns!

I plan to continue these enjoyable activities in the new year as well.

Give the 48-day challenge, an attempt! On any of the activities you like doing, you feel good doing but unable to do!

All the best to each of your individual aspirations!

For or Against NPS?

I had posted a few days ago, facts on NPS - it is available here.

Once in a few days, we would have got mail from NSDL saying to avail the additional tax benefit of Rs 50,000 per year under section 80CCD(1B).  So, if you are in 30% tax slab, it works out to a direct tax saving of Rs 15000 per year. So, it looks like Rs 15000 easy money.

But, just look at the the exit opportunity of Rs 50000 invested.

You can take out only after attaining age 60. And a mininum of 40% has to be invested in annuity. So, you can take out the lumpsum of a maximum of only 60%.  Out of 100%, 40% is tax free and the remaining is taxable at the appropriate income tax slab.

Let us say we take an annuity of only the minimum mandatory amount of 40%.

The split will be 40% taxfree lumpsum + 20% taxable lumpsum + 40% taxable annuity.

Two possible decisions:
1. Take the tax incentive and invest Rs 50000 in NPS
2. Do not take the tax incentive, pay Rs 15000 (@ 30% tax slab for the current year) and invest Rs 35000 in non NPS equity instruments (Long term capital gains being tax free).

For the ease of calculation, let us assume NPS and non-NPS investments generate the same CAGR over the years till the person reaches 60 years of age.  Assume the current investment becomes 10 times in about 30 years of time.

35,000 Non-NPS would have become 350,000 and this entire sum will be taxfree (assuming the current tax structure prevails after 30 years - big condition!)
50,000 NPS would have become 500,000
200,000 tax free
100,000 taxed at 30% = 70,000
200,000 annuity take which will generate just an inflation matching return beyond age 60

Current annuity table from LIC: https://www.licindia.in/Products/Pension-Plans/jeevan_akshay

@60 years of age, with return of capital, Rs 6600 is the annuity for Rs 1 Lakh purchase.  @15% service tax, for Rs 1.15 Lakh, annuity works out to be 5.74% - effectively just matching the inflation (and there is a possibility it might miss the inflation too in some years!)

And this will also be taxable.  Let us say, the annuity holder is still only at 10% tax bracket - then, net return is 5.74 * 0.9 = 5.17%  If the persion is in higher tax brackets beyond 60 years of age, the return further reduces.

@60 years of age:
Non-NPS is 350,000
NPS is 270,000 + 200,000 annuity

Effectively, the difference is :
Non-NPS is 80,000
NPS is 200,000 annuity with 5.17% return

Assume Non-NPS investment generates 3% higher CAGR - which is 8.74% and non-taxable.  At some point, the non-NPS will start accumulating more capital than the NPS one because of the higher compunding rate.
80000 * (1.0874) ^ (years) = 200000 * (1.0517) ^ (years)

It works out to be 27 years @ 3 percent better CAGR
It works out to be 18 years @ 5 percent better CAGR

NPS works out better if someone has an expectancy of around 80 years and do not foresee more than 5 percent better CAGR in non NPS investments (assuming LTCG in non NPS investments will be tax free)

All our analysis are based on our key assumption that till 60 years of age, NPS and non-NPS generate equal returns.  But, if the non NPS has compouneded at a better rate over the accumulation period till 60 years, then the scenario will be completely different with a tilt towards avoiding investing the tax incentivised NPS.

Mutual Fund Returns Calculator

I have published a SIP / SWP calculator, sometime back.  For now, it works with the Sensex data from Jan 1990.

The SIP calculator helps in calculating the CAGR / XIRR for
    1. Lumpsum Investments
    2. SIP Investments
    3. SWP Investments
   
SIP or SWP can be of daily / weekly / monthly / quarterly / yearly frequencies.

SWP is Systematic Withdrawal Plan where you have a corpus which is invested in an equity instrument (Sensex in this case) and from which a fixed amount is taken out at a regular frequency.

SIP - the assumption of calculating CAGR is that all the investments made at regular intervals compound at the same CAGR.

In SWP, if we have that assumption, then we also mean that the amounts taken out are reinvested at CAGR which may be an impractical assumption.  So, there is also an option given to modify the rate at which the withdrawals can be reinvested in.

Lumpsum / SIP / SWP calculator for Sensex

I am planning to update the calculator with the NAV values for Mutual Fund schemes - so it will be more useful.

MF Comparison Tools

Today, we shall see some tools which help in mutual funds comparison.

Morningstar's SIP Calculator - You can compare the SIP performance across three different funds.  But, it gives the performance review as on a particular date.  There are a few things that this comparator does not tell you:
1. How does a SIP perform across time periods, across different schemes?  This helps in selecting a scheme to invest in.
2. How will a daily or weekly SIP perform vs monthly or quarterly SIP?

FreeFincal (Dr Pattu) gives a rolling SIP returns calculator. He has a series of calculators on various components of personal finance!
https://freefincal.com/mutual-fund-sip-rolling-returns-calculator/
The way to interpret is this:  As on a point on X axis - say Aug 2013 (one of the lowest points of Sensex / Nifty), what would be my CAGR had I invested for the past 5 years (starting in 2008 Aug) and redeeming in Aug 2013?  It is 5% for rolling BSE Sensex.

Here, he compares the performance of several funds - HDFC Equity, HDFC Top200, Quantum LTE, IDFC Premier Equity against their benchmarks.  HDFC Equity and HDFC Top200 on the way to bottom, beats the benchmark - not good, losing more than the benchmark!  See Quantum LTE and IDFC Premier Equity - consistently beating benchmark and during the slide manages to lose less than the benchmark.

https://freefincal.com/nifty-200-dma-buying-high-vs-buying-low/
Here Dr Pattu analyzes whether there is an advantage doing SIP when the index (or the NAV) is less than the 200 day daily moving average vs index being greater than the 200 day daily moving average. The revealing and counter-intuitive observation is that the buying when the index is higher than the 200 DMA, the corpus is higher!

Systematic Investment Plan

SIP: Investing a certain quantum of money every month - in hope of accumulating a much higher sum in future.  An SIP is usually associated with the investment in mutual funds.  It is an MF version of erstwhile Recurring Deposit (RD).  Each investment in an RD can be treated as a monthly commitment towards a fixed deposit.  Let us say, an RD of 2 years, the first instalment stays for 24 months and the second for 23 months and so on - the last instalment stays for 1 month.  At the end of 24 months, the entire corpus collected along with accrued interest is returned to the investor.  The rate at which the interest will be accrued will be pre-fixed.  The first instalment generates interest for 24 months, while the last one generates interest for just 1 month.

A SIP in MF in that context is the same - you keep investing a fixed sum every month in a mutual fund scheme.  Except, there are a few caveats - which works well for investors with patience and may not work well for investors who are impatient.

There is no pre-fixed interest rate for SIP in MF.  By the way, there is no concept of interest rate at all, in mutual fund investments. If there is no interest at all, how does the corpus earns money?  On a daily basis, the mutual fund publishes Net Asset Value - NAV for all its schemes.  For an investment, units are allocated to investor based on NAV.  Let us say, the NAV of XYZ scheme is Rs 10.  An investor invests Rs 1000 today in the said scheme. 100 units are allotted to him.  Now, his money is converted into mutual fund units.  The next month, NAV falls to Rs 9.  Investor invests Rs 1000; 111.11 units will be allotted to him. Now after 2 months, his total units will be 211.11 and his Rs 2000 investment will be worth: 211.11 * 9 = Rs 1900.  So there is no guarantee that the investment will always travel upwards.  On the other hand if the NAV had risen to Rs 11, he would have got allotted 90.09 units and his total units of 190.09 will be worth 190.09 * 11 = Rs 2100

There might be very less chance of losing money in an RD in bank - though it might have lost the real value after accounting for inflation.  But there are good chances that a SIP, done for a shorter duration of time may end up less than the investment value.

At the end of RD, you need to mandatorily get back your amount - not necessarily the case in MF. You can keep the amount in MF to grow, even after the SIP period has ended.

Usually there is a penalty for premature withdrawal of RD.  Similarly, each investment of SIP has an associated exit load if withdrawn before certain period of time - the penalty percentage and the minimum commitment time differs from scheme to scheme.

By the way, RD is a product on its own; SIP is a way of investment.

CAGR - Compounded Annual Growth Rate is an important measure in determining how an investment performs over a given time period.  As on the day of evaluation, CAGR is the uniform rate which when applied for each instalment, accounting for the duration each instalment is invested for, would give the current amount - the total accumulated units valued at the current NAV. Sometimes, this CAGR is also called IRR or XIRR.

CAGR is one of the important benchmark in determining how the investment has fared over the years.  Though a point in time CAGR for evaluating mutual fund schemes is not so helpful.

Financial Calculator Suite

We earn and spend; Rinse - Repeat!  We really do not know how much it costs to earn and live, leave alone the needs for pursuing a passion!  As the income increases, the expenses catch up - unless planned.  Parkinson's law states "Work expands to fill the time available".  Similarly, the expenses increase to consume the income!  Planning is essential; setting aside an amount for future consumption is necessary.  People starting at age 25 and planning to retire at 55 have 30 years of work life and if they expect to live till 95 years, 40 years of retirement life. Assume there is no income in retirement, the 30 years of work life has to provide for 40 years of retirement!

It takes some math and compounding to estimate how much it is going to cost for expenses, when we retire.  To start with, one has to know what is the expense at the current level and how many years he has in his hands to retire and what is the contribution towards the retirement corpus that is going to be committed every year.

To help with such projections, I have created a simple application to help with the calculation.  This I call the "Calculator Suite for Retirement".  Consists of 3 parts:

1. Retirement Calculator: Projects the expenses and corpus and lets us know whether the current networth and the investment commitment till the retirment age will be able to provide for the entire life.

2. Annuity Calculator: Given a corpus and expected years for which the corpus is planned for, how much is the maximum annuity that can be withdrawn every year, assuming a given inflation

3. Corpus Calculator: Given a required annuity for a defined number of years at a set inflation level, how much is the corpus required?

Though I call it as a retirement calculator, this can be used for any defined goal - be it children's higher education, planning for a vacation, setting aside and building corpus for pursuing a passion, upgrading a house or a car - any such medium to long term goals.

Mohnish Pabrai TieCon Lecture

I watched another lecture by Mohnish Pabrai yesterday.

This was a talk on sales and marketing in TieCon Feb 2014.  The video was for one and half hours. Since it was a lecture, I did not watch it in full, but heard completely.  The full one and half hour was entertaining and captivating.  He started with how he initially thought of marketing was a jazzy or shiny or frivolous work and how his ideas changed after he read a few books by William Davido and Miller & Heiman in the late 1980s.  Those books are: Marketing High Technology, The New Strategic Selling, Successful Large Account Management and The New Conceptual Selling. Marketing is about the core value proposition that you put forth in what you believe.

The other books he mentions about are:
Power and Force - by Richard Dawkins - where he quoted on the idea of getting clues from sub conscious mind and keeping the communication channel (between the conscious and sub-conscious mind) free of clogging - so the message is sent across.

Origin and Evolution of New Businesses - by Amar Bhide - this is a research on the successful entrepreneurs and the best practices followed by them. Mohnish could relate to how he did his business with other people mentioned in the book - He gives his explanation of why he used the title "Vice President"

Tom Peters books: In Search of Excellence, A Passion for Excellence, Leadership

He has some very interesting anecdotes in the lecture.  His friend, then 19 years old, came up with the InstallShield software which was originally an after thought, non-buillt software listed as just a bullet point in a software exhibition at a conference.  A young person out from army, trained in making cables started a cable business, when he realised a demand, later went on to build a cable laying business.  These anecdotes he said on the necessity making things that customers want and of pursuing an idea wholeheartedly and changing it as per the needs of the customers and how the competitors evolve.

He says he is an expert cloner and never shies away in admitting the fact.  He shared his personal experiences of copying successful ideas (cloning) which he did in his business.  His experience in Mumbai with a jeweller who sent a greeting card every year - just to make himself remembered during a big wedding jewellery purchase - that made him to send cards to his customers.  A parcel he received from his law firm, where the organization name was written in extra large letters on the envelope - that made him to adopt a similar design for his business envelopes.  He says his Pabrai funds is a clone of Buffet partnership model which ran successfully for a decade till Buffet closed it in late 1960s.  He also says most of his stock ideas come from other investors.

Watch the video to experience!

Man's search for meaning

I have just started reading "Man's search for meaning" by Viktor Frankl, a psychiatrist and a II WW holocaust survivor. In the book, he writes about his experiences in the Auschwitz concentration camp and what made people to withstand and survive the terrible experiences - he says whoever had a "Why", a reason to survive had higher chances of survival than those who had lost hopes in between.  He willed himself of coming out and teaching psychiatry.  He chose to go to prison with his elderly parents, having his US visa lapsed.

He says: "Everything can be taken from a man but one thing: the last of the human freedoms; to choose one's own attitude in any given set of circumstances, to choose one's way".

There are multiple views of what makes a life: Life is a pursuit of happiness; Life is a pursuit of success.  In Viktor Frankl's view, life is a pursuit of meaning. And that meaning, the reason gives the life the support and balance to survive despite the circumstances.  If you have a "why", "how" does not really matter. He writes, "Life is never made unbearable by circumstances, but only by lack of meaning and purpose."

I have not completed the book in full. Will update more as I progress and finish.

My Financial Starter

I remember the first time when I got a job offer.  A software engineer job with a company based in Chennai with a good pay package. I felt it was a huge sum.  (It dawned on me later that it was not so big as I originally thought). My parents then, may not have been earning so much.  I was wondering what I would do with such a huge salary!  Once I joined the company, I wanted to plan my income tax and savings.  But, there was no body out in my circle of friends and relatives who could help with that. Adding to the complications, I changed my job in my first year itself.  I submitted all my investment proofs in the previous company.  The new company did not cut income tax for the few months when I worked. I was happy. Then, while filing the income tax, the auditors who came calculated a huge tax which I paid promptly - they were auditors right?  They must have calculated correctly!  The assumption was wrong.  The auditors added up the salaries at old and new companies and did not even take into account the investments I had made.  I realised it only later. I now consider that as a fee for learning how income tax filing works and a penalty for not doing my own tax returns filing.

There are some crazy things which I did in the first 2 years of my job.  Started a recurring deposit; bought some gold; bought a car in loan; opened a demat account and piled up around 30 different securities each for tiny sums; The craziest of all: Started a 6 month SIP! Adding to the list: 2 whole life LIC policies and another market linked one time premium ULIP from LIC apart from regular annual premium paying ULIP!

I was introduced to mutual funds by one of my colleagues.  He came with me to the nearest bank and helped me buy the first tax saving MF.  Later I opened a demat account and started trading in shares.  I bought mutual funds - so I know what shares to buy, right?  Again, wrong assumption!

It was not until after I finished my second tenure in college, I realised the importance of long term planning.

There are a lot of financial products available and not every thing is for everyone.  There are a few suited for some people which may be completely out of place for others.  And a few financial products are outright bad - helps the sales people and the product manufacturers at the expense of investors.  ULIP is the top name in that list.

As with the investment opportunities, are there the avenues and ways for expenditure.  Again, one needs to be watchful of mindless expenditure.  There are expenditure which people consider investments - this is a tricky trap.  If you expense on something considering it as investment, you are denying yourself an opportunity for learning as well.  Among these tricky traps are the expenses on car, car accessories, house purchase, house enhancements, mobile phones, laptops, bikes and many more!

How does a bank work?

A bank offers a number of  financial services among which, two are primary: It helps people to keep the surplus funds in safe custody and it helps people in need of money to utilise the money for a fee. The utilisation fee is called "interest".  A bank acts as an exchange between the "haves" and "have-nots" (usage not in the traditional sense) - As in modern times (with the traditional usage of the terms), it is the "have-nots" who keep the money and the "haves" who utilise that money - okay, leaving that aside.

Banks have to carry out the daily operations, pay the salaries of employees. Over and above, banks have to make profit to sustain in the business. So, they keep pocketing a portion of money that they get as "interest" from the borrowers and pay the remaining as the interest to the depositors. The depositors are of two types: "I want my money any-time when I ask" and another with: "Keep the money for 1 year, 2 year and give me at the end of the period" - The first category of people are the ones who keep savings account and current account with the bank - and because of the additional privilege of having money any time they need, the interest they get is typically lesser than the people who ask the bank to keep the money for a defined duration of time. Savings bank earn around 4% and there is no interest for the current accounts.  So, effectively there is a trade-off between higher interest versus liquidity. People would be willing to forgo a portion of their interest for the convenience of taking out money any time.  Between a savings bank and current account (the difference of 4% versus 0%), there exists a convenience premium for the current account holders to get money even when there is no balance left in the account (a facility called "over draft")

The Current Accounts / Savings Accounts (CASA) are the "demand liabilities" and the fixed period deposits are the "time liabilities" - Any deposit with a bank is a liability for the bank - it needs to pay back and also there is a continuous cash outgo from bank because of the same.

The borrowers take money from the bank for a fee which is ought to be paid monthly / quarterly or any specific period as agreed with the bank. Here again, the borrowers with whom the bank has enough trust in terms of past history or in terms of quality of the collaterals collected for the loan, get an advantage in terms of lower interest rate.  Borrowers with not so great credit background will have to pay more for the same loan, because the bank is taking an extra risk for which it needs to be compensated in the form of an additional interest.  When I say "high credit quality", it means the  probability with which the loan becomes a non performing asset (regular interest not being paid) is lower.

A bank cannot say to a depositor that 10% of its borrowers defaulted on the loan, so the depositors will get only 90% of the money. Because a bank offers such a protection, there must be a fee (which it gets in the form of interest rate difference between borrowing and lending) So, effectively, the depositors are lending to the borrowers with bank acting as an intermediary and taking the entire risk in the process.

What happens if some loans go bad? If the interest is not being regularly paid, beyond an acceptable limit, say 3 months, banks will treat the loan as non-performing asset (Means, loan is an asset for the bank because it generates the income - and since the interest is not being paid regularly - it is a non-performing asset). Once marked as non-performing asset, banks have to provision for the possible losses from the loan.  So, the provision takes a hit on the profit for the year. As bad loans increase, provisions increase. The sustained hits on profit later translate to a hit on the reserves and surplus, and slowly wiping off the equity capital of the bank, in which case the bank fails.

A bank is as good as its asset quality.

Primer on NPS

Quick Facts on NPS

NPS - New Pension System (also referred as National Pension System) is a contribution based retirement system promoted by PFRDA (Pension Funds Regulatory and Development Authority)

Tax Treatment:
Similar to PF, there can be contribution by employee and employer
Max contribution: 10% of (Basic + DA)
Employee Contribution: Falls under the limit of Rs 1.5 Lakh per annum - section 80 CCD (1), with other 80C schemes. (similar to how employee contribution of EPF is treated)
Employer contribution: 10% of (Basic + DA) is exempted under Section 80CCD (2) - this is beyond Rs 1.5 Lakh limit (similar to how employer contribution of EPF is treated) - i.e, not treated as income at all.
Additional Rs 50000 per annum (beyond Rs 1.5 Lakh limit) can be availed under Section 80 CCD (1b)

NPS has 7 fund managers to choose from - HDFC Pension Fund, ICICI Prudential Pension Fund, Kotak Pension Fund, LIC Pension Fund, Reliance Capital Pension Fund, SBI Pension Fund, UTI Retirement Solutions.

There are two accounts with NPS - Tier1 and Tier2.  Only Tier1 is eligible for tax benefits for investments.  Tier2 is more like an add-on for investor convenience.  Amount can be moved from Tier2 to Tier1 and not vice versa.

Amount contributed towards NPS gets invested in 3 different schemes - equity, corporate bonds and government securities. Investor can choose to invest in Auto mode or Active mode. Maximum possible contribution in equity scheme under both modes for any age is 50%.  Investor can choose to split the investments in Active mode, whereas in Auto mode the investment contributions get split as per investor age.  Rebalancing according to the target split happens yearly once on the date of birth of the investor.

The scheme details under each of equity, corporate bonds / govt. securties (E C G respectively) of Tier 1 and Tier 2 are available in the individual pension fund site
http://www.reliancepensionfund.com/navs/portfoliodetails.aspx?shortname=portfoliodetails
http://www.sbipensionfunds.com/portfolio-detail-system.html
http://www.hdfcpension.com/about-hdfc-pmc/investment-portfolio-details/

Minimum contribution
Tier1:
Minimum Number of times in a year: Once
Minimum Amount Contributed in a year: Rs 6000
Tier 2:
Once per year, Minimum Rs 250 (subject to a minimum funds available in Tier 2 of Rs 2000)

Fees
Minimum of 0.25% or Rs 20 per contribution (taken at the time of contribution)
0.0275% of funds under management for asset management, custodian and NPS Trust (adjusted in NAV)
Rs 190 per year for account maintenance taken by cancelling units in each of C, E, G

Withdrawal from NPS:
Possible only after age of 60
    A minimum of 40% to be utilized in purchasing annuity
    Maximum 60% can be taken as lump-sum
Premature exit
    Minimum 80% to be utilized in purchasing annuity

Taxation
    40% of withdrawal not taxable (only the available 20% lump-sum in case of premature exit)
    60% taxable - irrespective of lump-sum or annuity. Lumpsum taxable at marginal tax rate as per investor income slab for the year.
    Annuity purchase is not taxable, whereas the monthly payments from the annuity is taxable at appropriate slab.

Deferment of Withdrawal
    Defer annuity for 3 years
    Defer lumpsum withdrawal for 10 years
    Take lumpsum in a staggered manner in 10 installments.
    The entire withdrawal process can be deferred for another 10 years, during which contributions have to be made.

As of now, the following are the annuity providers from whom the annuity can be purchased.
    HDFC Standard Life Insurance Company Limited
    ICICI Prudential Life Insurance Company Limited
    Bajaj Allianz Life Insurance Company Limited
    Reliance Life Insurance Company Limited
    Star Union Dai-ichi Life Insurance Company Limited
    Life Insurance Corporation of India      

More Info:
    https://www.npscra.nsdl.co.in/all-citizens-faq.php
    http://www.hdfcpension.com/national-pension-scheme/nps-account/)

Now, analysis:
Assume a person of 30 yrs age is thinking of investing Rs 50000 (under extra tax exemption limit). He falls under 30% tax bracket.  He has 30 years time frame and two choices to make
   1. Go with NPS
   2. Pay tax and invest the after-tax amount in something similar
 
Let us assume the long term investment return over 30 years is 12% p.a.
 
Option 1:
   50000 * (1.12 ^ 30) = around Rs 15 Lakh
   40% withdrawal is tax free = Rs 6 Lakh
   20% withdrawal is taxed @ 30% = Rs 2.1 Lakh (after tax)
   40% withdrawal is utilized in purchasing annuity.
A quick look at  http://www.sbilife.co.in/sbilife/images/contentimages/AnnuityPlus_bi.htm shows that for a pension plan with refund of capital, the annual return works out to be 6.43% (after adjusting for service tax while purchasing annuity) pre-income-tax and 4.5% post income-tax at 30%   Rs 6 Lakh would give a monthly taxable pension of Rs 3218 and an effective post-tax pension of Rs 2252
 
Assume the person is living till 75 years of age and his hurdle rate is 10%. i.e he can borrow funds at 10%.
   With the post tax cash flows from annuity and his hurdle rate, this works out to be Rs 3.5 Lakh
   With 70 years life expectancy - this number will work out to be around Rs 4 Lakh.
   With 85 years life expectancy - this number will work out to be around Rs 3 Lakh
 
   @12% hurdle rate:
   70 years: 3.46 Lakh
   75 years: 2.94 Lakh
   85 years: 2.47 Lakh
 
   So, the total cash proceeds @ age 60 can vary from  6 + 2.1 + 2.47 = Rs 10.57 Lakh to 6 + 2.1 + 4 = Rs 12.1 Lakh depending on life expectancy and hurdle rate.
 
 
   Option 2:
   35000 * (1.12 ^ 30) = around Rs 10.486 Lakh (Assume 50% equity and 50% is is Corp / Gov bonds)
   50% Equity LTCG is tax free.
   50% C / G LTCH is taxable in indexed fashion. So, 5.243 lakh - 17500 = Rs 5.068 Lakh is LTCG, which is Rs 88250 adjusted for indexation.
   Tax payable @ 30% on Rs 88250 Lakh = Rs 26475
   Net Cashflow at age 60 = Rs 10.486 - Rs 0.26475 lakh = 10.221 lakh
 
There are some questions to be addressed.
1. What happens on the death of NPS investor before 60 years of age?  Will nominee have to pay tax - to what extent?
2. When NPS is deferred for 10 years till age 70 and contributions are made, what happens in the event of death.

40% is taken tax-free. 20% is taxed (Less 6%), 40% is taken as annuity which one never sees it again, except in the form of monthly pension - which is constant all through his life expectancy.  No way to increase or decrease pension.

Even, with current tax benefit, the positive side is around Rs 0.35 Lakh to Rs 1.88 lakh which in current terms with the same long term return (12%) assumed is around Rs 1170 to 6275

All this, assuming the current 30% tax benefit. And after accounting for the 2016 change in tax treatment (that 40% of NPS corpus at age 60 is not taxable).  Otherwise, NPS makes no sense at all.

Still, one loses the independence by locking in the money for long term and locking in by purchasing the annuity for even longer term (possibly)

Take away:
1. Do not purchase beyond 40% of corpus in annuity.
2. While choosing annuity option, go for annuity with corpus refund - otherwise it is too risky if the investor dies very soon after purchasing annuity.
3. Defer it by 10 years, then defer annuity by 3 years

Talks at Google: Mohnish Pabrai and Guy Spier

I wrote about reading the book Checklist Manifesto, a few days back.  The author Dr. Atul Gawande talks about his interview with Mohnish Pabrai, a renowned investor.  Mohnish Pabrai says that so many investing ideas pops up every day, which pumps up the adrenaline - but, as you put those ideas through a well prepared checklist, you would sense most ideas are baseless and may not be pursued.  I have heard about Mohnish Pabrai, but have not attempted to dig deeper.  Yesterday I saw one of the google talks where Mohnish Pabrai and Guy Spier (who has written the book "The education of a value investor") speak about their experiences.

On watching the video, I became a fan of Mohnish Pabrai!  What a clarity of thought, and what narrative style he possesses! He talks about his investment in Satyam in 1994 / 95 time frames and how in a span of 5 years, he has made his $10000 to 1 million+ and got back the same in USD, sitting in USA.  That is a 100 bagger for him.  He says when he looked at the financials in 1994, he sensed Satyam was massively undervalued.  The real estate it owned in Hyderabad might have been above the market cap.  On another opportunity, he says, irrespective of high valuation of PeopleSoft when he decided to make money out of that, and having not invested, created a back door entry in the form of selling PeopleSoft consulting / services and made a high margin business out of it, with effectively a negative capital!

He shares his experiences with an industrial psychologist in 1999 / 2000 time frame who provided him with his "owner's manual" and how it helped him in becoming better at his focus areas.  He recommends everyone to have an "owner's manual", by consulting with a trained psychologist! The personal experiences are candid and succinct. He also shared two of his failures where he came out of a stock in 3x or 4x multiples which eventually became more than 20x or 50x

Mohnish and Guy Spier successfully bid for Lunch with Warren Buffet in 2007 and in this video, they talk about the surprising fact from their perspective in that lunch.

This is a 2015 Google talks video.  After more than 1.5 years, it has hit only 28k views!  Strong recommendation to watch.

Comparison of MFs - 3 Year CAGR

I proposed how a point in time comparison of CAGR across mutual funds may not give much information.  Yesterday, we saw how the CAGR return distribution of 3 year, 5 year and 7 year in the same fund fared against each other.  Today we take a specific set of 3 funds - no recommendation - the funds have been in operation for a longer period of time.  UTI Equity Fund, Birla Sunlife Frontline Equity Fund, Franklin India Bluechip fund.  For these funds, 3 year lump sum investment CAGR is calculated for 7 years. For investments from Apr 2006 to Apr 2013.  So, the total number of data points would be around 250 * 7 = 1750 individual lumpsum investments.

A cumulative distribution plot is generated for the 3 funds which look like below:




Median return of BSL Frontline is better than UTI Equity which in turn is better than Franklin India Bluechip. And if you look at y=0.25 line (at 25%), we get that 75% of returns are upwards of 9% in UTI Equity and upwards of 8% in the other 2 funds.  Take the y=0.75 line, 25% chances that the returns are around 16% in Franklin India Bluechip and around 20% in the other two funds.

To view in terms of returns, for a 15% or above return, BSL Frontline has a 45% chance (1 - 0.55) and 38% chance with UTI Equity, 33% chance with Franklin India Bluechip.

In general, the curve on the right is better - for the same return you get a better probability. In a real scenario, we would never get these lines running parallel, so you can choose the one on the right most!

Equity is a long term investment

We recently saw that it may not make so much sense taking a single point return (as on a particular date).  Instead of looking at a MF scheme page and assuming it gives a CAGR of 12%, 14% and 13% respectively for 3, 5 and 10 years, how about actually getting a sense of how the return distribution looks like over a large set of data.

Here, I have tried to plot the return distribution for a large cap equity fund.  The data is taken from AMFI website.  The data is available only from 2006. I have taken 7 years data (making up for around 1750 data points) for 3-year lumpsum investment, 5 years data (1250 data points) for 5-year lumpsum, and 3 years data (around 750 data points) for 7-year lumpsum investment.

Here is the graph that we get:

Red, Green and Blue represents the 3 year, 5 year and 7 year return distributions respectively.  Some points to observe: The returns are not negative (no loss of capital) in the 5 year and 7 year investments - but be aware that the data points considered are less and may not even cover one investment cycle or business cycle.  But, the 7 year investment would have had investments made in the high of Jan/Feb 2008 and redeemed in Jan/Feb 2015.  Still, it did give a positive return.  There is 75% chance (observe the horizontal line of y-axis=0.25) that the CAGR is minimum 9% in 3 and 5 year lumpsum and 11% in 7 year lumpsum. Median CAGR is 13%, 12% and 13% respectively, means there is a 50% chance that CAGR is minumum the median amount.

25% chance that the CAGR is minimum 16% in 5 year and 7 year lumpsum investments and a minimum 20% in 3 year lumpsum investment.  Also, see the shapes of the curves.  The 3-yr red curve deviates widely compared to green (5 yr) which deviates more compared to blue (7 yr).  Means, the volatility in terms of observed CAGR increasingly gets reduced as the holding duration increases.

The dataset taken is very minimal but you get the idea. Equity is for long term. Better to hold for a longer term!

In next post, we shall see how we can use this for comparing mutual funds.