LTCG tax on equities – How to calculate?

Since I have started writing this blog there has been three budgets and I normally get a lot of queries after every budget. In this budget, understandably the maximum number of queries have been in the tax treatment of equities, where LTCG has been taxed at the rate of 10 %. I was thinking of doing a post on this but a CBDT circular clarifying the different scenarios has made my task easier.

As I do not believe in reinventing the wheel, let me just reproduce here what the circular says. I am doing this so that people reading my blog have easy access to it:-

The computation of long-term capital gains in different scenarios is illustrated as under‑

Scenario 1 — An equity share is acquired on 1st of January, 2017 at Rs. 100, its fair market value is Rs. 200 on 31st of January, 2018 and it is sold on 1st of April, 2018 at Rs. 250.

As the actual cost of acquisition is less than the fair market value as on 31st of January, 2018, the fair market value of Rs. 200 will be taken as the cost of acquisition and the long-term capital gain will be Rs. 50 (Rs. 250 — Rs. 200).

Scenario 2 —An equity share is acquired on 1st of January, 2017 at Rs. 100, its fair market value is Rs. 200 on 31st of January, 2018 and it is sold on 1st of April, 2018 at Rs. 150.

In this case, the actual cost of acquisition is less than the fair market value as on 31stof January, 2018. However, the sale value is also less than the fair market value as on 31st of January, 2018. Accordingly, the sale value of Rs. 150 will be taken as the cost of acquisition and the long-term capital gain will be NIL (Rs. 150 — Rs. 150).

Scenario 3 —An equity share is acquired on 1st of January, 2017 at Rs. 100, its fair market value is Rs. 50 on 31st of January, 2018 and it is sold on 1st of April, 2018 at Rs. 150.

In this case, the fair market value as on 31st of January, 2018 is less than the actual cost of acquisition, and therefore, the actual cost of Rs. 100 will be taken as actual cost of acquisition and the long-term capital gain will be Rs. 50 (Rs. 150— Rs. 100).

Scenario 4 — An equity share is acquired on 1st of January, 2017 at Rs. 100, its fair market value is Rs. 200 on 31st of January, 2018 and it is sold on 1st of April, 2018 at Rs. 50.

In this case, the actual cost of acquisition is less than the fair market value as on 31stJanuary, 2018. The sale value is less than the fair market value as on 31st of January, 2018 and also the actual cost of acquisition. Therefore, the actual cost of Rs. 100 will be taken as the cost of acquisition in this case. Hence, the long-term capital loss will be Rs. 50 (Rs. 50 — Rs. 100) in this case.

I hope with this all the readers would have got a very clear idea on how the tax is to be calculated. However, the more serious issue is the real impact of the tax on your investments you have been making for the long term.

The news on that front is unfortunately not a good one – I will explain in the next post.


The impact of budget on your investments

When you are in the middle of a storm it is difficult to stay calm. The immediate aftermath of the budget yesterday has been a sharp fall in the markets – the fall is significant for the Sensex and the Nifty and brutal for the mid cap and the small cap indices. I thought of writing this post about the overall impact of the budget on your investments but it will probably be a good idea to start with the markets first.

Now as any of us who have been in the markets for some time will know, the markets do not like surprises. In the budget of yesterday, there were 2 elements which were not really surprises, yet the markets were hoping against hope that they will not take place. The first is the fiscal deficit figure whose importance is really in how the world views us financially. Not only have we not met the projected 3.2 % but, what is far worse, we are pegging the next year target too at 3.5 %. The financial discipline which was the hallmark of the last few budgets seem to be slipping. The second is of course taxing of LTCG for equities. While this had to happen some time, the markets are clearly shocked at it being done now and in not doing away with STT. Out of the two factors, the first will spook the FII’s and the second will be more of a problem for domestic investors. It was therefore expected that the markets will fall today, but the extent of the fall has been shocking.

Let us take a look at the LTCG part in closer detail. There are several issues in it which have not been understood well. By and large, people investing in stock markets are the relatively better off people in our society as compared to those who do not. It will be unfair not to tax LTCG at all, given the increasing income disparities we are seeing in society today. So if the government had to run welfare schemes such as Ujala and the Health scheme the money had to come from somewhere. This was the obvious choice and the other was raising the cess from 3 % to 4 %. I am a little surprised that LTCG period has only been kept at 1 year. This along with the little difference from the STCG rate will mean that there is really no incentive for holding equity long term.

Let us now look at what it means for investors in tangible terms:-

  • All your gains made so far are well protected as the price on 31st Jan, 2018 will be taken as the cost price. Though you will be charged for future gains from this price, your current valuation of portfolio is protected.
  • If you sell your stocks and MF in the next FY, it will be possible to structure the sale so as to minimise the taxes. For example every one of us will have some stocks in our portfolio which lose heavily. This will be the time to square off these losses with the gainers so that you do not have to pay much taxes. 
  • As far as MF goes most of us are doing it for some long term goal and we can just continue to do so. Yes, you will pay some taxes on future gains but not on your past ones. Investors doing SIP should simply continue, you may now want to bump up the amount by 10 % to take care of the taxes when you redeem. Note that this is mainly true for the Growth option.
  • If you have chosen the dividend paying option in your MF investments then the DDT will come into place from April. You will now roughly get 10 % less dividend as compared to what you were getting earlier. If this forms part of your passive income then you will need to secure this gap from somewhere else.
  • Indexation not being there is a good thing as you can simply sell it now at any point in time, without worrying about the indexed cost price. In any case, indexation works best with debt products where the returns are linearly unidirectional.

In summary what should your actions be?

  • Clean up your portfolio by selling stocks you do not want to keep, especially if they are losing money. Make sure that your overall gains after squaring off the lasses are not more than 1 lac so that you need not pay any taxes next year.
  • Continue with SIP in your MF investments, look into increasing the monthly outlay to take care of the eventual taxes.
  • Dividend option in MF schemes is a bad idea now. You will be paying DDT twice and again pay taxes on LTCG. Go for the Growth option, if you need money you can simply sell off some units.
  • Rest of your investments in Debt etc can continue as before.

So you will see, there is no real reason to panic at all at an individual level. The markets are doing so as they had gone up a lot and would anyway have corrected. This bad news has given it a reason to do so now. If it was not this it would have been something else.

My current MF portfolio – Open ended Equity funds

Readers who are familiar with my blog for some time will know that I have 3 portfolios of Stocks, MF and Debt. It is my strong belief that the 3 portfolio strategy is ideal for any situation and provides for adequate growth while containing the risks to a good degree. Out of these I normally write mostly on my stock portfolio as that is the one which needs more knowledge and is also what most readers want to know more about.

However, in the last week I have received several queries as to how I went about building my MF portfolio over time, what schemes do I currently have, do I still do SIP and so on. As my MF portfolio is quite diverse, let me try and answer this in 3 parts. The first is covering the Open ended Equity funds, the second the Close ended Equity funds and the last will deal with Debt and Hybrid funds.

In chronological order, this is how my Equity MF investment journey has been :-

  • My first introduction to MF was in 2001 through a Financial Adviser. We invested in Franklin Bluechip and ICICI Technology fund for about 1 lac overall. Both of these are still in my portfolio and have done reasonably well, though I have not added much to these over the years.
  • My next foray into MF was only in 2005 as in the interim period our focus was on building the stock portfolio and paying off the home loan. In the 2005 – 2006 period there were a spate of NFO from fund houses almost every month. I bought regularly in this period for a total of about 4 lacs – most of these have been sold off now, mainly in 2007 when the markets ran up really high.
  • Introduction to MF investing through SIP started in 2008 when the markets were down and I needed an alternative to buying stocks. We were doing SIP regularly into a portfolio covering 4 funds in different categories. Over the years, some of the funds changed but the investment was regular till October 2015.
  • After 7 years of my SIP journey, I realised it was not really the best way to invest for an investor like me, who had good knowledge of the markets. I started to target buying at opportune times and also looking at MF schemes with long term themes.
  • After I gave up my regular corporate career, I have invested heavily in Close ended Equity NFO, in order to take short term benefits from market as well as to have an income source from dividends.
  • Right now I do not invest in Equity MF schemes unless they are of a specific theme. These investments are mainly into NFO buying.

Let me now give a snapshot of my portfolio. As before, I will try to focus on the schemes where the current portfolio value is more than 1 lac. There are a few other funds which I have in my portfolio but they are not significant in value. I will not get into the mode of acquiring the funds, SIP or one time buying as that again is not very relevant.

So here are the categories and funds from the regular open ended schemes:-

  • Large cap and Diversified equity funds in my portfolio are:
    • HDFC Top 200 
    • ABSL Frontline Equity
    • DSP BR Equity
    • ICICI Dynamic Plan
    • ICICI Focused Bluechip Equity
    • ICICI Value Discovery Fund
    • ICICI Exports and Other Services
    • UTI Dividend Yield
    • UTI Nifty Next 50 ETF
    • Franklin India Bluechip
    • CPSE ETF
    • Reliance Regular Savings 
    • UTI Bluechip Flexi Cap
    • HDFC Premier multi cap
    • BNP Paribas Long Term Equity 
  • Mid and small cap funds in my portfolio are:
    • Franklin India Smaller Companies
    • Sundaram SMILE
    • Sundaram Select Mid Cap
    • IDFC Premier Equity
    • DSP BR Micro Cap
    • HDFC Mid Cap Opportunities
  • Some other open ended funds I have with required value are:
    • L & T Tax Advantage
    • ICICI Prudential Technology
    • Franklin India Life Stage FOF
    • ICICI Prudential US Bluechip equity
    • Franklin India Dynamic PE Ratio FOF

Some numbers then – the above funds constitute about 62 % of my Equity MF portfolio. The rest are made of Close ended funds and smaller investments. 

I will address the Close ended funds in my next post.

Portfolio Management Services – are they good for you?

Over the past few years my equity portfolio has been at a reasonable level. Thanks to my friends, acquaintances, bank people and readers of the blog this is a fairly well known fact too. I have consequently been approached by several individuals as well as Fund Houses with the offer of managing my portfolio for me. Even though I have not gone for any PMS so far, these interactions and my own reading has helped me to get a fairly good idea of this.

So to start with, a PMS is not all that different from a MF at a basic level. In an MF scheme the Fund manager gets money from multiple individuals and creates a portfolio out of those funds. He then runs that portfolio for certain fees and people can continue to invest in the scheme. Returns from the scheme are in terms of dividends and also capital gains from the portfolio. In a PMS most of these are also true, except that the amounts are larger and it is being done for a single individual. Let us review this in a little more depth. I will take a specific example of one PMS I was offered recently, without naming it.

The salient features of the PMS proposed to me is as follows:-

  • Minimum ticket size is 25 lacs. This could be in cash or also in terms of a 25 lac stock portfolio at current market prices.
  • In either case a new Demat account will be opened and all transactions will be in that account after the initial transfer of the shares.
  • You are giving a mandate to the PMS manger to execute trades on your behalf in this portfolio. While you can be involved if you want, that really defeats the whole purpose of having a PMS in the first place.
  • Typical charges are 2-3 % and they are normally upfront. However, there is a lot of scope for discounts and some PMS work primarily on a profit sharing model.
  • Returns on the PMS are obviously not guaranteed but over long term most have managed to give 20 % and above after deducting the PMS expenses.
  • The chances that the PMS will be successful are reasonably high as the manager is dealing with a concentrated portfolio and can take the right kind of calls based on the research available at his disposal.
  • More importantly, the PMS manager is not emotionally invested in the portfolio and therefore is in a better position to take sell and buy calls compared to the investor.

The last point is the most important one. As investors we suffer from an endowment bias working on both the buy and sell sides. For example, I bought Maruti years back and it has grown manifold after that. While that gives me great pleasure, I am not very likely to sell it, even if I realise that in the next year that money can be utilised better elsewhere. A PMS manager will probably sell it at 8000, use the money on a beaten down stock like Yes Bank for a year and then buy it back if needed. This helps him to make more returns than I would. Similarly, I have stocks such as NDTV and RCOM which have gone nowhere and I still have issues about selling them. This is because I want to avoid the pain of loss and admission of a mistake. The PMS manager will have no such considerations.

So is PMS a good idea for you? Well, if your stock portfolio is more than 50 lacs or so then you can look at it. Separate out the stocks which are not doing well and give it to the PMS. Review the performance after a year and check if it makes sense to continue. Remember to really negotiate hard on all costs as the standard costs are quite high, but they are negotiable too. Try to get into the profit sharing model to the extent possible.

Why is the PMS always likely to give better returns than an MF scheme? Well, for one it is a concentrated portfolio with a finite value. This enables the PMS manager to take quick calls, unlike the MF manager who has to deal with much larger amounts. Secondly, in a PMS there are no redemption pressures within the year. Thirdly, constant inflows through SIP forces the MF manager to keep investing, even if the time is not right. This is not the case in a PMS. Fourthly, an MF manager will mostly buy standard company stocks unless there is a very specific mandate to do otherwise. A PMS manager has far more flexibility in this regard and can really create value for the investor. Fifthly, if the markets crash the PMS manager can sell off quickly to limit the damages. This is not really feasible for a MF fund manager having a large AUM.

Remember that your equity journey should start with Mutual funds, then get into stocks and finally graduate to a PMS only after you have a substantial stock portfolio. If you start with putting your first 25 lacs into a PMS, your experience may be a bad one and scar you so badly that you distrust any equity investment thereafter.

Finally, then is the PMS a good idea? On the whole, I will be inclined to agree though I am still trying to make up my mind as to if I should go for it. In case I finalise the PMS, I will do a future post on it.

Should you be selling equity now?

The liquidity driven rally in the indices and several stocks has been the flavor of this festive season. In the beginning of this financial year the opinion of most analysts were that there can be a possible range bound movement and the Nifty would probably settle in the range of 9500 to 9800 over the next few months. Thereafter things would be taken care by the last quarter results. Indeed when the markets started to rally and crossed the 10000 levels with relative ease, the consensus was that the corporate earning would justify the rise.

Now that several companies have declared their results for the second quarter, it can be safely said that the results have been a mixed bag and there is nothing really in them to indicate strongly that the lacklustre showing of corporate results are a thing of the past. In fact while the Auto companies and several banks have shown encouraging results many other sectors have been clearly disappointing – IT, Engineering and Pharma to name a few. So what does this portend for our markets, the Nifty in particular? 

For starters, there are really no immediate triggers left for the markets. Both the GST and the good monsoons have largely been factored in the rally which we have witnessed in the past few months. In any event, the actual impact of these are not being felt in the Q2 results. Given this situation it is kind of tough to see Nifty getting a serious lift from the present levels. Yes, the liquidity factor along with some other good news can push it to near 10500 levels but it will be very difficult for it to sustain it there. In simple terms, I think that there is a far greater case for a Nifty downside to 9500 and below in the next 2 months as opposed to an up move to 11000 levels. In this context, does it make sense for an investor to sell off his equity holdings partially and enter later at lower levels? 

People who are holding a direct stocks portfolio will be familiar with this simple mechanism. You can move out of a stock at a level where you feel there is unlikely to be any more upside in the short run. Over a period of time you can decide at what level would you like to re-enter the stock. At the very least you would try to add to the stock at certain lower levels, even if you do not book profits. Of course, this requires a deeper understanding than just looking at Nifty levels but the rewards can really be stupendous. There are people who sold Maruti at 4600 last year and then bought it back around 3500, to now see it climb back to 4700 again. If you owned even 100 shares of Maruti, this strategy would have given you a cool tax free profit of 1.2 lacs.

What about MF in that case? Most investors who are into SIP are led to believe that they should adopt the Hero Honda strategy of, “fill it, shut it, forget it”. But in reality is this a good idea? Like in the case of Maruti stock, will you be leaving a lot of money in the table if the Nifty really goes down rapidly from here and your MF scheme NAV declines alarmingly. At some level, your fund manager is taking care of this but it will do no harm to take an active stance in this as well. Many investors have investments of 3-5 lacs in an MF scheme. Even a 10 % drop in the Nifty levels will mean significant amounts of money. Remember, this is clearly like a tax free bonanza that you can use for many of your discretionary expenses and even for additional expenses if you so desire.

More importantly, many of us have collected stocks and MF schemes over a long period of time. These do not fit into our current plans very well but we may have been too lazy to sell them or have not found it worthwhile. With the market levels being where they are for all types of indices, it may be a pretty good idea to sell some of these. You can channelise the money into your current portfolio depending on the right market levels. Also, if you are stuck with a long standing SIP in a fund which you do not like any more, this will be the perfect opportunity to get out of it lock, stock and barrel.

Is there a risk that Nifty can just go up unidirectional and well past 11000? I do not think so and even if it does, it will come down at some point. Remember you will be holding cash and that is also an asset.

In the next post, I will outline how I want to adopt this strategy for my own investments.

Do Equity returns compound? No !!

In my last post I had written about the frequent wrong usage of Maths to create misconceptions in investing which are not factually true. One such glaring misconception is for investors to feel that there will be compounding returns on equity investments, at least over the long term. This is simply not true and I would have thought that most investors would be able to understand this. However, as I have got quite a few queries and requests for clarification, let me do so here.

To start with let us fundamentally understand what Compounding is. I have used the following definition from Investopedia:-

DEFINITION of ‘Compounding’

The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.

Essentially compounding involves some positive return on your asset, irrespective of what the return might be. Due to this the absolute value of your investment will always be increasing. Note here that we are not talking of inflation and Real returns here. For example, if I have a FD of 1 lac Rs and it pays me an interest of 8 % today then at the end of 1 year I will have an amount of 1.08 Lacs. Now if inflation is also at 8 %, my real return ( interest rate – inflation rate) is 0 and I have not really gained anything in terms of my purchasing power through this investment. At the same time, the absolute value of my investment has definitely grown by 8000 Rs in the one year period. This 1.08 lacs becomes my principal amount in the next year and I earn interest on this new amount. So in effect, compounding entails my earning interest not only on the principal amount but also on the interest amount.

The usage of compounding logic works great with debt products where the interest rates are relatively stable. Take an FD as an example again. At 8 % interest rate your money will double in approximately 9 years, at 12 % rate it will double in approximately 6 years and so on. Your money always grows in absolute terms, ignore the real growth for this discussion.

Now let us look at equities and see if this logic can be sustained in the light of our knowledge of it. If you look at stock prices over a period of time, you will see that it is clearly not so. Let me give you some examples from well known companies and their share prices from fairly recent memory:-

  • ITC reached 400 Rs and is now down to 300 odd levels.
  • HUL went to 1000 and then declined to levels of 800.
  • Reliance has had negative growth over years, so has Tata Steel.
  • Some company shares like Kingfisher Airlines have become penny stocks today.

There are also many examples of company shares having done extremely well and generate spectacular returns. My point here is simple – equities can give great growth but the way to understand that is not through the compounding principle. The growth in equity is non-linear and carries serious risk with it. Now at this point, people may tell you that over the long term of 15-20 years the compounding logic will hold true for equities. Sorry, it does not – if you bought the shares of Deccan Aviation at 146 Rs in the IPO , you have lost this money pretty much forever, never mind how long you are going to wait.

When I think about why there is such a great misconception about something really straightforward, I could come up with the following reasoning in my mind:-

  1. Most people invest in equity through Mutual Funds. As a MF scheme maintains a portfolio of stocks, the overall NAV of the scheme would normally increase in a reasonably good market, which we have had in recent years.
  2. Of course, the above can change in a prolonged poor market, but not many of today’s investors have had this experience. 2008 through 2010 was such a phase but has been mostly forgotten now.
  3. The usage of CAGR term, somehow makes one think that equity investments compound. This, of course, is complete nonsense but I have seen many sensible people believe this. CAGR is an artificial construct to understand annual returns, it in no way says that such returns are stable and not even that they are positive. In fact you can have negative CAGR and negative IRR / XIRR quite easily.

So, if it is clear by now that compounding logic is irrelevant to equities then how do we go about financial planning with equities as an investment asset class? I will answer that in a future post. For now, do understand that you cannot just hope that you will invest in stocks and it will give you an XIRR of 15-20 % because that has been the historical returns in the index. I really wish life were that simple for me and you, but it does not work like that.

Take heart though – we can make great returns from equity, by understanding the correct ways of investing in it.

Interested readers may pls follow my blog on email by clicking on the relevant button on the right hand panel. I will shortly be stopping the practice of posting the links in different Facebook groups. Following the blog will ensure you get intimated whenever there is a new post.

How will the Nifty perform now and in 2017?

As expected the Nifty levels hit a fresh high as a result of the positive sentiments emanating from the election results. The market players like stability and after the results there was renewed FII buying. However, it was not a runaway rally as many had predicted for 2 reasons. Firstly, a lot of the possible BJP victory in UP had already been factored in. Secondly, there are some serious factors which will come into play in the medium term.

So to address the first issue, where does one see the Nifty in the next week or so? Given that the March expiry is next week both transactions and medium term fundamentals will be pertinent. From all technical analysis the Nifty has serious resistance levels at both 9180 and 9220. If it is able to cross both these points then it is likely to rally for a couple of hundred points more. However, in terms of probability that is rather unlikely and like this week, the markets will probably be range bound. On the down side Nifty has strong support at 9050 and again at 8975 levels. In case both of these break there is every possibility of a deeper correction in April. Again, in probabilistic terms this scenario is also not very likely and therefore, we will probably be in a range of 9050 through 9200 for most part in the week.

What about 2017 then? Well, many analysts believe that an overall growth of Nifty by 15-25 % in the year is possible. So, given that we started 2017 at levels of 8000, we should be able to get close to the 10000 mark. As usual, there are many factors that can make this happen or prevent it from happening. Here are some of the key ones.

  • GST implementation from July 1st
  • Monsoon performance and whether the EL Nino effect is a serious one
  • US Fed rate hikes and impact of it on FII buying in our markets
  • Earning growth showing positive signs finally in this FY
  • Infrastructure spending by government to increase in the next 2 years or so

What is my call on the Nifty? Well, I think we may well get close to 10000 by the end of this FY but the path will obviously not be a linear one. There is a possibility of a sharp correction of about 10 % and that may well happen in the months of May and June, especially if the monsoon predictions turn negative and the GDP and IIP numbers show an unexpected decline. The route Nifty will take from 9100 now can well be as follows, though predictions are hazardous : 9100-9250-8700-8500-9000-9400-9200-9500-9700-10000. Each of the ranges may last for several weeks or months. While the route is tough to predict with any real degree of accuracy, I do think Nifty will end with 9700 plus by the end of this FY and may very likely get to 10000.

What does this mean for your investments this year and how should you plan them. Let me get back to this in another post.