1.

Article on Diversification

There is a recent article in The Financial Times (Link: http://www.ft.com/) by

Steve Johnson titled Does a share of commodities action makes sense? The
article probes if investing in commodity equities is a better option for achieving
investment diversification as compared to investing in commodity futures. The
writer mentions a recent paper written by Mr. Xiaowei Kang (director of global
research at S&P indices) which states that at least for long term investors
commodity equities provides similar diversification benefits.

The article mentions the divergent opinions of experts, about the diversification
benefits of the two options - commodity equities and commodity futures. The
argument seems to about the degree of correlation between commodity stocks
and broad based stock index. If the correlation is high the diversification benefits
are likely to be limited. But the article seems to be missing another aspect which
is vital from an investors point of view. The benefits of diversification have to be
evaluated along with the cost of obtaining that diversification. If the cost of
investing in commodity equities is much lower that investing in commodity
futures, they are likely to be a much better bet for gaining exposure to
commodities and obtaining diversification benefits.

Another aspect of diversification that is not evaluated in the article is the choice
of products an investor has when he is investing in commodity equities and the
choices he has when he is investing in commodity futures. It is quite likely that
the choices in commodity futures prove bewildering for an investor. The
complications in the product structures are also something to be evaluated. A
choice of too many products with structures of varying complexity may result in
wrong investment decisions. Human nature being what it is, the possibility is
high that an investor starts evaluating a product class for diversification benefits,
gets confused due to a wide range of choices and ends up buying a product for a
completely different reason than the one he had in mind initially.

Thus to compare the diversification benefits of commodity equities and

commodity futures, one has to look beyond the correlation of products and take
practical considerations like cost of obtaining that diversification and the
complexity of the product class into account. It is quite likely that a simple
product which is likely to cost less in management fee (due to its simple
structure) provides more diversification benefit, even if the correlation among
the product classes is a little higher.

2. What is Impulsive Wave

Shakespeare once said Whats in a name? That which we call a rose by any
other name would smell as sweet.But most often the meaning of a technical
term is hidden in terminology itself. Given the context and the words, you can
deduce the meaning of the difficult sounding but conceptually easy technical
terms.

Impulse wave is a technical pattern from the Elliot wave theory. If you have only
a passing idea what technical patterns is about you should be able to guess that
impulse wave must a pattern in which there is a sudden price movement. More
specifically impulse wave pattern is a strong movement in the price of a stock,
which is coinciding with the underlying trend. The main direction of the
underlying trend can be either upward or downward.

3. Public company approach to Valuation

Valuation is something fundamentally important in finance. Importance of

valuation is self evident in many cases. For an investor finding the right valuation
can be critical, for if the value of any company is much less than the price
(market capital) it is a buying signal. If the value of a company is much more
than the market capital, it means that the company should be sold from the
investment portfolio. Similarly investment bankers are also interested in valuing
a company. Based on the estimates of the value of the company (or a part of the
company) they decide if a merger or acquisition is worth doing.

But valuation is more of an art than hard science. A great investor can look at the
financial statements of a company and after ruminating over them for a few
hours tell you how much the company is worth. But he may have difficulty in
explaining to you how he did it. For instance many people over the years have
asked Warren Buffett how he makes those valuation decisions so quickly. He
shrugs and says that it has taken him decades of practice to do it. Truth is he
may not be able to explain even if he wanted to. It is like asking a fish, how do
you swim?

However, there are a few standard techniques that can help you in getting
started with valuation of companies (it will take years before you become a
master). One of them is public company approach to valuation. The basic idea is
simple. You have a business in mind, whose value you want to determine. You
look for publicly traded companies which have a very similar business model (to
the company you have in mind), and use them as a benchmark to measure the
value of the company in question.

For instance you may want to value a small food chain which has 10 outlets in
downtown Manhattan. Such a company is too small to be listed on any of the
stock exchanges. But there are some bigger food chains which are listed. So you
zero in on a food chain which is listed and has a similar business model to the
smaller food chain in downtown Manhattan (say selling Indian food). And you use
a financial metric to compare the two companies. Say the bigger food chain is
selling at the market value of $100 million while it has revenue of $10 million.
Now the market value to revenue ration is 10. So if your smaller food chain has
revenue of $500,000, you can estimate that it should be worth close to $5
million, by assuming that market value to revenue ration should be same in the
two cases.

To get more specific and technical you have to use a valuation multiple to
compare the publicly traded company with the similar business model and the
company whose valuation is to be estimated. In the example mentioned just
before we used market capitalization to revenue ratio. There are other multiples
you can use like Price to Earnings, Price to Cash flow, Price to EBITDA, Price to
EBIT and many other sundry combinations. Essentially all these multiples include
a measure of value in the numerator (Price or Market capitalization, where
Market capitalization is nothing but price multiplied by the number of shares),
and a measure of financial performance in the denominator. Cash flow, EBITDA,
EBIT and Revenue are all indicators of financial performance. Instead of
measures of financial performance, you can also use measures of operational
performance like number of employees, number of registered users and number
of customers in the denominator. The natural question is which is the best
multiple to use?

We are afraid that there is no clear cut answer to the question. All multiples have
their positives and negatives. If there was one multiple which could trump all
others in all situations, then finance would be way too simple. There would be no
need for human valuation experts and spreadsheets and computers would be
able to accurately assess companies. But it takes sound human judgement to
decide which valuation multiple is best suited for comparing two companies.

It is a challenge to find the best multiple, but you can do well by inverting the
problem. To elaborate, you should remember in what circumstances it is ill
advised to use a particular multiple. For instance, Price to Earnings multiple (PE)
is a popular choice among investors and analysts. But PE ratios are severely
distorted when a company has significant amount of cash in its balance sheet. So
if the comparable large food chain in our example holds a large proportion of
cash in its treasury, you know you have to steer clear of using PE for comparison.

Revenue based multiples (Price to Sales or Enterprise Value to Sales) are also
popular among certain class of investors. But these multiples are usually valid
only for companies that have a very similar profit margin. If we refer to our food
chain example once again, we used a revenue based multiple when we assumed
that Market Capitalization ( or Market Value ) to Revenue should be same for the
two companies. But such an assumption is only valid if the profit margins of the
two companies are similar.

EBITDA and EBIT are preferred over earnings, if there is a lot of difference in
financial leverage and tax effect in the two companies that you are comparing.
Between EBITDA and EBIT, the choice depends on capital expenditure and
depreciation. If capital expenditure is lumpy and varies significantly from
depreciation, then EBITDA is the preferred choice. Otherwise EBIT is the right
option.
Finally there is the question of time period to be used in the measure of the
multiple. In the food chain example, the implicit assumption was that market
value was measures at the present value and the earnings were of one financial
year. But many investors and analysts prefer to use average of 3 years in the
earnings figure. You need a lot of practice and experience before you can
exercise your judgement in such cases.