Q&A: Mutual Funds vs Direct Equity, Differences in P&L and CF

Modified on July 22, 2018

The current article in this series provides responses related to:

  • Choosing between mutual funds and direct equity
  • Differences between interest and tax expense in P&L and CF statements

 

Query

Thank you Sir for the insightful article. One question I have. Rather doing all these due diligence would it be better for any retail investor deploy her money through MF route? Because if she is not able to generate a return more than well performing MF then, would it make sense to spend enough effort to this process?

It would be really helpful if you can spend few minutes and clarify if I’m thinking pessimistically and/or I’m missing something.

Thank you once again for this article!

Author’s Response:

Hi,

Thanks for writing to me! I am happy that you found the article useful.

If an investor believes that she does not have time to do stock analysis on her own, then she may utilize the services of MF or PMS.

However, if the investor has the time & can put in required efforts to do her own stock selection, then she can capitalize on the multiple advantages that being a retail investor brings to her. This is in addition to the savings on the annual expense ratio of about 2%, which MF and PMS charge, which amounts to a very significant sum over long periods.

Read: Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks

You may get the idea about the advantages, which retail investors enjoy over institutional investors as below:

 

A) No dependence on equity portfolio/markets for day to day living expenses:

A retail investor does not have to depend upon her earnings from equity portfolio to meet her day to day expenses like rent, EMI, children school fee, kitchen expenses etc. Her salary from the day time job is most of the times sufficient for these expenses. She does not need to get under stress if a company in her portfolio does not declare a dividend in any quarter. Whereas a full-time investor might face cash shortfall in meeting her household expenses, if her portfolio earnings are not as per expectations.

B) Gets investible funds at every month-end:

A retail investor, if she manages her household expenses well, is able to save some surplus funds at the end of every month from her salary. This surplus or savings provide her regular source of funds, which she can invest in her equity portfolio. The fact that these funds are not dependent upon the performance of equity markets, empowers the retail investor to have the discipline of investing regularly irrespective of market performance. She can easily invest this additional money in new opportunities, without unnecessary churning in her equity portfolio.

A full time investor, whose only source of income is from equity markets, does not enjoy this benefit of regular source of funds every months for deployment in her equity portfolio. A full time investor might have to churn her portfolio i.e. sell existing stocks to generate funds, in case she finds an attractive opportunity in the equity markets. This portfolio churning might or might not prove to be a successful decision every time.

C) Can take long-term investment views:

A retail investor does not have to prove her portfolio performance to anyone. She is not being judged by markets/third parties based on the performance of her equity portfolio. As a result, a retail investor can afford to stay calm and behave in a peaceful manner irrespective of equity market results. She can easily focus her aim at the long term performance of the companies in her portfolio as she is not being questioned about her portfolio on a regular basis.

An institutional investor does not enjoy such freedom. The fund management team is continuously under scrutiny for the performance of the funds that are under their management. Most of the institutional investors, mutual funds (MF), private equity (PE) funds etc. have to disclose their performance to their investors regularly (daily for MFs, quarterly for PE etc.). The fund manager is continuously under pressure to showcase good performance whenever she sends out the periodic performance report to the investors. Even otherwise, large investors of the funds keep on calling/enquiring the fund managers about performance of their money.

Such continuous monitoring of performance, many a times, leads to short term defensive investment approach by fund managers, which is focused on avoiding tough questions from investors.

Read: Getting The Right Perspective Towards Investing

D) Can benefit from bear phases/lower stock prices by buying more:

As mentioned above, a retail investor is not answerable to anyone for her investment decisions. She can take her portfolio decisions without the need of such decisions looking justifiable to others. This ability gives an immense power to the retail investor to benefit from bear markets when she can add on to her favourite stocks, which are available at cheap prices. She can keep on buying stocks despite a continuous decline in stock prices.

An institutional investor does not have this unrestricted freedom. As mentioned above, all her decisions have to be approved by a board of trustees and have to be justified to large investors. In such a situation, institutional fund managers, most of the times avoid buying stocks when prices are falling as the fund manager might have to face tough questions on underperformance of the fund if the stock price of her newly bought companies does not recover soon enough.

Read: How to Earn High Returns at Low Risk: Invest in Low P/E Stocks

E) Hold back buying when stock prices are high:

A retail investor does not have an obligation to invest her surplus funds in the equity markets as and when she get the salary. The retail investor can hold back the buying decision and sit on cash until she believes that the stock prices are available at attractive levels.

Many institutional investors like mutual funds, do not have such freedom. Mutual funds have to invest a certain portion of their funds in equities, which is determined by their fund guidelines/prospectus. E.g. if a mutual funds has the mandate of investing 90-100% of its funds in equities, then it has to keep at least 90% of funds invested in equities all the time irrespective of valuation levels of stocks in the markets.

Such mandated guidelines create hard times for mutual fund managers, who face fund movements at precisely the wrong times. Most of the mutual funds see higher investment by investors in bull markets when stock prices are rising. As a result, to maintain the minimum equity investment proportion, the mutual fund manager has to invest the fresh funds in stocks despite high valuations.

On the contrary, many a times investors withdraw their funds from mutual funds in bear markets. The fund manager to meet the fund requirement of redemptions has to sell the stocks when the stock prices are falling.

As a result, the mutual fund managers end up buying stocks in rising markets and selling stocks in falling markets. This is buying high and selling low, which is against the key principle of equity investment, which says that investors should buy low and sell high.

A retail investor is spared this forced buy high and sell low situation faced by mutual funds, as she does not have any obligation to invest funds available to her as she does not have a mandated equity allocation to be followed all the time irrespective of market valuation levels.

You may read more about the key guidelines for retail investors while investing in direct equity in the following article:

Read: 3 Guidelines for Selecting Stocks Ideal for Retail Equity Investors

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

Query

Dear Sir,

I have a query regarding a textile company Vardhman Textiles Ltd. In 2016 Annual report, page no. 71, Standalone Tax expenses was Rs. 211.58 Cr. and 2016 Standalone Interest expenses was Rs. 86.85 Cr. But in the Cash Flow Statement Tax expenses was Rs. 232.34 Cr. and Interest expenses was Rs. 133.31 Cr. Could you please explain why this kind of huge difference in Tax and Interest expenses between Profit & Loss statement and Cash Flow statement ? Are these worrying signs? And how important is it from investors’ perspective?

Author’s Response:

Hi,

Thanks for writing to me!

Companies show the tax expense in the P&L, which is calculated as per the rules of the Companies Act. However, in the CF statement, the tax outflow shown is the amount paid to income tax as per the rules of Income Tax Act. As many a times, the two acts treat many expenses differently, therefore, the profit of the company in P&L statement and the income tax return filing is different. Therefore, the companies end up paying different amount in tax to Income Tax Dept. than what they have shown in the P&L. These differences in the tax figures in P&L (as per Companies Act) and CFO (as per Income Tax Act) form one of the basis of deferred tax assets & deferred tax liabilities.

Similarly, the interest figure in the CF statement includes the interest outflow which is expensed in the P&L as well as the interest outflow, which is capitalized as part of the project cost and shown as part of fixed assets/CWIP. Therefore, the interest expense figures in the P&L and CF may differ.

This is normal accounting practice.

Read: Understanding The Annual Report Of A Company

An investor should always assess the interest servicing capability of a company by considering both the P&L interest figure as well as the capitalized interest figure.

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

P.S.

 

DISCLAIMER

  • The above discussion is only for educational purpose to help the readers improve their stock analysis skills. It is not a buy/sell/hold recommendation for the discussed stocks.
  • I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.
  • Currently, I do not own stocks of the companies mentioned above in my portfolio.

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“Peaceful Investing” approach is the result of my more than a decade of experience in equity markets. This approach helped me invest even when I had a full-time corporate job and could not spare a lot of time for stock analysis. During my investing journey, I have faced all the common challenges of the investors, the biggest one being “scarcity of time”. “Peaceful Investing” approach keeps in mind that an investor will have limited amount of time to spare for stock investing. 

The objective of “Peaceful Investing” approach is the selection of such stocks, where once an investor has put in her money, then she may sleep peacefully. Therefore, if later on, the stock prices rise, then the investor is happy as she is now wealthier. On the contrary, if the stock prices fall, even then the investor is happy as she can now buy more quantity of the selected fundamentally good stocks.

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