Trying to simplify finance, does it work?

These days there are so many finance influencers on YouTube, authors of personal finance books, and online and in-person courses on managing money, but are the investors getting any better?

Seeing things the way they are

A lot of YouTube influencers pass on strong advice to the novice investor. There are so many influencers who were promoting crypto until the fall happened.

There is no problem listening to these videos, but acting upon them can be disastrous. I believe that knowledge can help you advance but too much information will make you not act at all.

Here is a simple step-by-step process for managing your money better.

1. Cash flow analysis and net worth: Understand your inflow and outflow of funds, your current asset and liability position and what you want to achieve. There are many calculators to do this assessment. https://www.plutuscapital.co/calculators

2. Asset allocation: Based on the cash flow surplus and financial goals arrive at an asset allocation. You must also consider the risk profile that you would like to maintain whether it is aggressive, moderate, or conservative.

3. Execute and monitor: Implement the allocation and keep a watch.

These steps are so simple yet so difficult to implement.

Any financial outcome is a combination of your life situation, capital market conditions and your behaviour. All these three areas are dynamic and ever-changing.

Some things can be known, and some things cannot be known.

Life situations and capital market conditions can be observed, and a decision can be made. For example, you know that an increment or a promotion may happen, or you are about to change your job or get ESOPs encashed etc. These events can be known in advance and a decision can be made.

Similarly, capital market conditions can be sensed (over or undervalued markets) and a decision can be made.

However, personal behaviour is the most complex aspect that even professionals will have a challenge dealing with.

Here is a speech by Charlie Munger on “the psychology of human misjudgement”. This speech is all you need to know about human psychology.

Psychology+of+Human+Misjudgment

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Download PDF • 1.91MB

Reading can help but will that make you wise?

Not really!

Awareness of ourselves will make us wise.

A finfluencer or a book author cannot make you wise because they are dealing with their own biases. They are just passing on those biases to you, invest in start-ups, invest in ETFs, invest in crypto etc. Who knows, maybe keeping your money in a bank’s FD is the best option.

One of the ways you can become a better decision maker whether about money or any other thing is to see life the way it is without adding any extra meaning. Easier said than done.

Our Indian tradition has given a lot of importance to ‘consciousness’ and not so much to ‘mind’.

When you are looking at a problem, you need to reflect on which aspect of your mind is dominating - ego, intellect, or memory. If your mind is at work, chances are that the decision is not optimal.

Ego will always make you stick to your decision (status quo bias). Intellect will not help you look past your analysis (overconfidence). Memory will restrict you to what you have seen in the past (anchoring).

To evaluate any problem, you need to ensure there is neutrality in your emotions. You should be able to see the problem vertically and horizontally and once you have decided, it will just ‘feel right’.

This sense can be applied to any problem you are trying to solve - investing, life, hiring a professional, relationship etc. The decision that feels right will turn out to be right. Pre-condition is the neutrality of the mind and seeing things as they are.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

How can US and Canadian NRIs invest in India?

Mutual funds, AIFs etc. are not tax-efficient solutions for the USA and Canada-based NRIs. There are more straightforward options to address this issue.

USA and Canada NRI Investment Options

The global economic environment is challenging, and the respite is not any time soon. High inflation is expected to stay in the western world, and it will keep interest rates elevated for some time. So much so that the USA is dealing with inflation that they last experienced these elevated inflation levels a few decades back. Globally, the future growth prospects do not look bright.

On the other hand, India managed its monetary policies better than a lot of western countries. Although RBIs current inflation target is 4% (with a 2% threshold), the average inflation over the last 20 years has been around 7% p.a. The latest data indicates 6.5% as India’s inflation rate. India’s primary concern about inflation is the oil price. Given that the global economy might be under low growth headwinds, India stands strong.

As per the world bank report, India is expected to be the highest-growing economy in 2023 and 2024. A young population, China +1, Production linked incentives, and India’s payment stack are some of the areas that can help India double its GDP in the next 5-7 years.

It’s not a surprise that NRIs want to invest in their home country. Indian tax laws and security laws are pro-foreign and NRI investors. Like most of the major countries in the world, India has a bilateral tax treaty in place. This means double taxation can be avoided for investors. Recently, SEBI has made KYC norms more stringent for NRIs so that money laundering issues can be avoided. Irrespective, there is a massive inflow of funds to India to capture the expected growth.

In India, NRIs and Residents are treated at par. However, local tax laws can wary. In India, a simple way to invest is by using mutual funds. The process of mutual fund investments for a US / Canada-based NRI is as easy as for resident Indians.

However, the local laws (USA IRS and Canadian tax laws) are not tax efficient for mutual fund investments. If you are an Indian living in the USA, it is most likely that you have come across the term PFIC. PFIC is an acronym used for Passive Foreign Investment companies.

Simply put, if you are invested in an Indian Mutual Fund, you must declare the investment and income in the US. If you are a joint income tax filler in the US, you are exempted up to Rs 50 lakhs ($25,000 each). However, if you are invested more than Rs 50 lakhs (Rs 25 lakhs singly), you are not just required to report to IRS but also pay taxes on the unrealised gains.

Indian tax laws do not differentiate but must follow FATCA rules and report to the US counterparts. Even if you don’t report to IRS, still the information is shared with the US authorities. A few mutual funds offer investments to US-based NRIs but beyond $25k, it does not make sense for US investors to allocate to Indian mutual funds. Similar laws prevail in Canada too.

One way to address this issue is to hold investments directly and not in a fund structure. This way you don’t have to pay taxes on the unrealised gains.

Additionally, Alternative Investment Funds (AIFs) fall in the same category as PFIC, making AIFs also not a good investment vehicle for US-based NRI investors. Another, investment option is investing in India using Portfolio Management Scheme. Investment using PMS is tax efficient both in India and in the USA. Interestingly, there are not many PMS accepting money from US/Canada-based NRIs.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337

WACC, the most debatable topic in Finance

Any asset can be valued by discounting its future cash flow via a discount rate. This discount rate is called the weighted average cost of capital.

CAPM is not a good tool to calculate WACC

Most finance professionals have been taught to calculate the cost of equity using the Capital Asset Pricing Model (CAPM) and the cost of debt as a risk-free rate plus a credit spread.

Cost of equity = Risk-Free Rate + Beta X Market Risk Premium


Cost of debt = Risk-Free Rate + Credit spread

Terminal value = Free cash flow / (Cost of capital – growth) 


Let’s assume free cash flow is 1000 and growth at 4% and see the difference. 


Terminal value = 1000 / (8.5%-4%) = 22,222


Or 


Terminal value = 1000 / (9%-4%) = 20,000 


A difference of 2,222 can be huge, depending on the context.

We can see that relying on the capital asset pricing model is not wise. Rather than a precise number, even our ballpark number is good enough. 


“Cost of capital is what could be produced by our 2nd best idea, and our best idea has to beat it.” – Warren Buffet

In the Indian context, our second-best alternative to equity is government security. However, we want to find out the cost of capital within the Equity group.

There are more than 6000 companies listed on NSE. However, all the companies are not the same.


“Think of three types of ‘savings accounts.’ The great one pays an extraordinarily high-interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will also be earned on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.” – Warren Buffet

Great business: High Return, High Growth

Example: Asian Paints, Nestle India

These businesses have a predictable cash flow. The risk attached to the cash flow is minimal. 


Good business: High Return, Low Growth

Example: HDFC bank, HCL tech

These are good businesses, but cash flow growth is less predictable.


Gruesome business: Low Return, Low Growth

Example: Airtel, DLF


When you are investing your money, you should focus your efforts only on great and good businesses. Instead of using a capital asset pricing model, we can use a range-based cost of capital.


1. Equity returns: Since the weighted average cost of capital is a form of expected return, an easy way is to find out what has been the average expected return. The return would vary from the lowest category of risk to the highest category of risk. Please note that our definition of risk is only linked to the loss of capital and not to volatility.

A 10-year government bond security yield is around 7.5%, a large cap return is around 10%, a MidCap around 13% and a small cap around 15%. Even the most predictable cash flow-based equity will have some premium over a 10-year government bond yield so we can assign 7.5% +1.5% = 9%. So, the broad range is between 9 to 15%.

Depending upon the predictability of cash flow, you can assign the cost of equity. A feature of great business would be predictable cash flow, hence a lower cost of equity. Similarly, a good business with a less predictable cash flow may require a higher range of cost of equity.

2. Dividend-based approach: this is another approach to understanding the cost of equity. In simple terms, it is the dividend growth rate plus the expected GDP growth rate plus inflation.

An average dividend yield is around 1.5% plus the expected GDP growth of India is 6% plus the higher end of the inflation band which is 6% so the total is 13.5%.

Now the company may have an expected return growth rate of more or less than the GDP. For example, Colgate will have a lower GDP growth rate than India's GDP whereas CDSL may have a little higher GDP growth rate.

Another variation could be companies deriving their revenue from global markets. For example, the TCS growth rate can be associated with the global GDP growth rate. So, the adjustment should be done using the global GDP growth rate of around 3%. And in the global context the expected inflation is also less that is around two or 3%.


The capital structure may include debt as well. You can look at the recent borrowing by the company and use that as a proxy for the cost of debt. Apply relevant weights based on the capital structure and accordingly come out with the cost of capital. 


It is better to be roughly right than precisely wrong. This is the reason using a range of cost of capital and applying that range to the company’s Cash flow is a better approach than using the capital asset pricing model.

When you are valuing a good or great company, one of the indicators of a good or a great company is a high return on invested capital. Value creation potential is linked with the difference between the return on capital and its cost of capital. A company generating a 30-35% kind of return on capital will not need a precise cost of capital number (9% vs 10%). Even if it is ballpark, you know that it will not meaningfully impact your assessment. This is the reason we call 'investing the last Liberal Art'.

In case you are looking at gruesome companies, the precise cost of capital is extremely important. Gruesome companies have a low return on capital. Even the most experienced investor cannot arrive at a precise cost of capital. Therefore, valuing a gruesome category of a company is speculative at best.

“It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much.” – Charlie Munger

Based on the quality of the business, a broad range of costs of capital can be worked out.

Disclaimers

• Investment in securities market are subject to market risks. Read all the related documents carefully before investing.

• The securities quoted are for illustration only and are not recommendatory.

• Registration granted by SEBI, membership of BASL (in case of IAs) and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors.

Details of the advisor

• Advisor: Ankur Kapur

• SEBI RIA No.: INA100001406

• BASL Member ID: BASL1337