Term of the Week

Term of the week

Term of the week

Mid Cap Companies have smaller turnover, market share and balance sheets in comparison to large cap companies and larger turnover, market share and balance sheet in comparison to small cap companies. Although Mid Cap Stocks are more extensively covered than small cap companies, they tend to be less researched than large cap stocks.

Going by SEBI’s circular, these are the 101st to 250th traded companies by market capitalization. Moreover, as per SEBI’s classification, equity mutual fund schemes which invest at least 65% of the total assets in midcap stocks are categorized as midcap funds.

Since the stock market segment of the mid cap funds are not as liquid as large cap segment, it is considered to be more risky. On the other hand, these schemes have a lower risk than the small cap funds, consequently, the riskometer is usually moderately high.

Therefore, there is a considerable scope of price discovery in the mid cap segment with respect to the large cap; fund managers can tap the potential of under-valued mid cap stocks and deliver potential returns to investors in the long run. But, midcap stocks are much more volatile than large cap stocks, so, the investors should be prepared for high volatility.

Debt Mutual Funds

These are the 100 largest traded companies by market capitalization as per SEBI’s circular. By market capitalization, we refer to the share price multiplied by the number of outstanding shares of a company. Moreover, as per SEBI’s classification, equity mutual fund schemes which invest at least 80% of the total assets in stocks are categorized as large cap funds.

Large cap companies have large sized balance sheets and fairly large market share in their respective industry sectors. Therefore, they have management depth, large organizations and adhere to certain standards of corporate governance. Talking about the riskometer profiles, these schemes are moderately high risky schemes.

One of the most important terms in equity investing, Price Earnings Ratio or PE ratio is the ratio of share price to earnings per share (EPS). In other words, it can be defined as the payment you have to make to buy Rupee 1 of EPS of a stock. This ratio helps in analyzing whether a stock is expensive or cheap, where a high PE ratio can imply that a stock is expensive, while a low PE ratio may imply that a stock is cheap.

However, the usage of PE Ratio is not limited to just one interpretation, because a high PE Ratio also implies that investors are ready to pay more to buy Rupee 1 of EPS and this is because they expect the earnings per share of the stock to grow faster in the future. Similarly low PE ratio can imply that investors do not expect the EPS to grow very fast.

Also, PE Ratio contributes towards an individual’s investment strategy. Talking about the growth, investors, like to invest in stocks which are expected to give high EPS growth and are therefore, ready to pay more for such stocks. Value investors, on the other hand, want to invest in stocks that are trading at low prices. As a result, Growth stocks have high PE ratios and Value stocks have low PE ratios.

Operating margin is the ratio of operating income to the revenue of a company. Operating income can be defined as the profit of the company before paying interest and taxes. Operating margin is an important financial ratio and is an indicator of profitability of a company.

This ratio helps us to know how efficiently a company is using its assets and therefore, companies with operating margins are liked and preferred by the fund managers and analysts since they are likely to deliver higher earnings growth. If the companies have same growth rates in revenues, the one with higher operating margins will provide higher profit after tax (PAT) or earnings per share (EPS) growth compared to a company with lower operating margin.

However, while looking at the Operating Margin, one should take care of not comparing this ratio of the companies across sectors. For example, businesses which have less pricing power (e.g. commodities) tend to have lower operating margins than businesses with strong brands which have higher pricing power.

Dividend yield can be defined as the dividend per share divided by the share price. It is an important ratio which helps in selecting stocks; where valuation wise, high dividend yield stocks are more attractive as compared to low dividend yield stocks.

It is considered as an important ratio for value investors as high dividend yield stocks usually give returns in volatile and down markets; even if share prices are down, investors get cash-flows in form of high dividends. However, it is important to know for the investors that high dividend yield stocks will not necessarily give returns than low dividend yield stocks. Dividends are paid from the profit after tax (or earnings per share) of a company. Profit after the tax can either be paid out as dividends to shareholders or re-invested back in the company or combination of both, at the discretion of the management of the company. If the management thinks that there are opportunities to invest in the business for higher revenue and earnings growth then it will reinvest a greater share of the profit after tax in the business and consequently have a lower dividend payout rate (lower dividend yield). Higher earnings growth in the future, may lead to higher share price appreciation and future potential returns for shareholders. Some companies on the other hand, may want to distribute a bigger share of the profits to shareholders and consequently have higher dividend yields. High dividend yield stocks are value stocks and tend to be more stable / less volatile than low dividend yield stocks. Investors should make informed decisions based on their risk appetite and investment goals.

Earnings per share or EPS refers to the profit after tax of a company divided by the total number of shares outstanding. It is the measure of profitability of a company; higher the EPS usually better is the profitability. EPS is considered to be the most important factor in share price appreciation and therefore, this ratio is looked upon very carefully by the Fund managers and analysts when selecting stocks for investments.

EPS can be impacted by various factors like spin-offs, divestitures, acquisitions etc. The reported EPS numbers are normalized by the analysts so that they can make like to like comparisons for quarter on quarter or year on year EPS growth. Apart from EPS growth fund managers, analysts place a lot of importance to earnings visibility. Many companies also provide guidance on future EPS growth but companies may not be able to provide near term or medium term guidance during economic downturns. Apart from management guidance, analysts also try to analyze EPS growth to various factors like:-

  • Is it due to improvement in operating margins?
  • Market share
  • Share buybacks
  • Is it due to growth in sales?
  • Increase or decrease in financial leverage (debt / equity ratio)
  • Pricing power of the company

Companies with consistent high EPS growth and good earnings visibility are mostly preferred by the investors.

Equity mutual funds are mutual fund schemes which invest primarily in equity and equity related securities of the companies. Although the historical data of these funds shows us that equity is the best performing asset class, these also are categorized as the highest riskiest investments. For investing in equity funds, it is recommended for the investors to have a high risk appetite since the risk profile of equity funds range from moderately aggressive to aggressive. Equity funds can be classified into several sub-categories depending on their investment characteristics. As per SEBI’s directive, following are the different equity fund categories based on their market cap characteristics:-

  • Large cap funds
  • Large and midcap funds
  • Multi - cap funds
  • Midcap funds
  • Small cap funds

Further classifications are based on investment strategies / styles e.g.

  • Focused funds
  • Value funds
  • Dividend yield funds

Most equity funds are diversified having an investment in themes or sectors which are known as thematic and sector funds respectively. Although sector funds are considered to be among the riskiest equity fund categories, these investments may give potential returns if planned well in terms of entry and exit. However, which category of equity fund you invest in, you should always have a long investment horizon and high risk appetite for equity investments. Further, it is always advisable to consult your financial advisor before investing.

Repo Rate refers to the interest rate at which the commercial banks borrow money from the Reserve Bank of India (RBI), in case there is a temporary shortfall in funds. Repo rate is the benchmark interest rate in our economy.

Repo Rate is one of the tools of RBI to regulate the money supply in a country; if the Repo Rate increases, there is less incentive for banks to borrow money from RBI, therefore, Repo Rate hike reduces the amount of money supply (liquidity) in the banking system. Consequently, Repo Rate helps in controlling inflation; when inflation is high, RBI increases the repo rate to control inflation by reducing money supply. On the other hand, when economic activity is not in a good state and inflation is low, RBI can reduce repo rate, encouraging banks to lend to increase economic activity (GDP).

It is the most important interest rate of our economy and provides a fundamental basis of interest rate setting for deposits and loans by banks.

Bond prices decrease in response to an upward movement in interest rates, likewise bond prices increase when interest rates decrease. Because of this inverse relationship between bond prices and yields (Interest rate) it is important to know how sensitive the bond price is to interest rate changes.

The Modified Duration is a measure of the price sensitivity of the bond to interest rate movement, it helps in predicting how sharply the market price of a bond will change as a result of changes in interest rates.

For instance, the Modified Duration of a debt fund is 2.7 years then a 1% increase in interest rates can result in a 2.7% decrease in the value of the fund. Similarly, a 1% decrease in interest rate can lead to 2.7% increase in the fund value.

Key Points:

  • The duration of a debt fund is used to infer how the value of the portfolio would change in response to changes in interest rates.
  • The higher the modified duration of a debt fund, the higher its sensitivity to market interest rates.
  • If interest rates are expected to fall down (which implies bond prices will rise), it is advisable to invest in long duration funds and if interest rates are expected to raise (which implies bond prices will fall), it is advisable to invest in Short duration funds.
  • Short duration funds like liquid fund or ultra short term fund will have low duration and long term funds like Long term bond fund will have higher duration.

Macaulay Duration is among the key factors that helps in measure the risk of the fund, Just like the risk in equities can be measured through standard deviation, the risk in bonds can be measured through Macaulay duration.

Macaulay Duration is the weighted average term until the present value of the bond's cash flows equals the amount paid for the bond. In simpler words, Macaulay duration is the time an investor would take to get back all his invested money in the bond by way of periodic interest as well as principal repayments.

For Instance:

Face value₹ 1,000
Maturity7 Years
Yield to Maturity4%
YearsCoupon AmountMaturity ValueTotal Cash FlowPresent ValueDuration (weighted average)
1₹ 50-₹ 50₹ 48.080.05
2₹ 50-₹ 50₹ 46.230.09
3₹ 50-₹ 50₹ 44.450.13
4₹ 50-₹ 50₹ 42.740.17
5₹ 50-₹ 50₹ 41.100.21
6₹ 50-₹ 50₹ 39.520.24
7₹ 50₹ 1,000₹ 1,050₹ 797.915.59
Macaulay Duration6.47 years

Key Points:

  • Relationship with other factors:
    • As maturity of bond increases, duration increases.
    • Increase in bond’s Coupon will result in reduction of duration.
  • Macaulay Duration can help investor choose the right debt funds to suit their investing horizon. 

The materials are a part of Investor Education and Awareness initiative of Mirae Asset Mutual Fund.

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